1.3.2: Externalities

Question 1

What is an externality?

Answer 1

• The cost or benefit a third party receives from an economic transaction.

Question 2

What are private costs/ benefits?

Answer 2

• The costs/ benefits to the individual participating in the economic activity

Question 3

What are social costs/ benefits?

Answer 3

• The costs/ benefits of the activity to society as a whole.

Question 4

What are external costs/ benefits?

Answer 4

• The costs/ benefits to a third party not involved in the economic activity.
• They are the difference between private costs/ benefits and social costs/ benefits.

Question 5

What is a merit good?

Answer 5

• A good with external benefits, where the benefit to society is greater than the benefit to the individual.
• These goods tend to be underprovided by the free market.

Question 6

What is a demerit good?

Answer 6

• A good with external costs, where the cost to society is greater then the cost to the individual.
• They tend to be over-provided by the free market.

Question 7

What is a marginal cost/ benefit?

Answer 7

• The extra cost/ benefit of producing/ consuming one extra unit of the good

Question 8

What is the marginal private benefit (MPB)?

Answer 8

• The extra satisfaction gained by the individual from consuming one more of a good

Question 9

What is the marginal social benefit?

Answer 9

• The extra gain to society from the consumption of one more good.

Question 10

What is the marginal private cost?

Answer 10

• The extra cost to the individual from producing one more of the good and the marginal social cost

Question 11

What is the marginal social cost?

Answer 11

• The extra cost to society from the production of one more good.

Question 12

When do negative externalities of production occur?

Answer 12

• When social costs are greater than private costs
• eg noise pollution, air pollution, industrial waste

Question 13

When do positive externalities of production occur?

Answer 13

• When social benefits are greater than social costs
• eg healthcare and education

Question 14

What are the ways in which governments can intervene to ensure the market considers the external costs and benefits?

Answer 14

• Indirect taxes and subsidies
• Trade pollution permits
• Provision of the good
• Provision of information
• Regulation

Question 15

How do indirect taxes and subsidies ensure the market considers external costs and benefits?

Answer 15

• Taxes can be put on goods with negative externalities and subsides on goods with positive externalities.
• These help to internalise the externalities, moving production closer to the social optimum position.

Question 16

How do tradeable pollution permits ensure the market considers external costs and benefits?

Answer 16

• These allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them choice whilst reducing the total level of pollution

Question 17

How does the provision of goods ensure that the market considers external costs and benefits?

Answer 17

• When social benefits are very high, the government may decide to provide the good through taxation.
• They do this with healthcare and education

Question 18

How does the provision of information ensure that the market considers external costs and benefits?

Answer 18

• Since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs

Question 19

How does regulation ensure that the market considers external costs and benefits?

Answer 19

• This could limit consumption of goods with negative externalities, for example banning advertising of smoking etc