3.8.4 - Positive and Negative Externalities in Production and Consumption Flashcards
What are externalities?
A public good or a public bad that is ‘dumped’ on third parties outside the market.
When do externalities exist?
When there is a divergence between private and social costs / benefits.
What type of good is an externality?
A public good.
What type of good is an externality?
A public good.
Why is an externality a special type of good?
It is ‘dumped’ on third parties who are forced to consume it, whether or not they want to.
What is a postitive externality?
An external benefit that occurs when the consumption of a good causes costs to a third party, where social cost is greater than the private cost.
What is a negative externality?
When the consumption or production of a good causes costs to a third party, where social cost is greater than the private cost.
How can negative externalities be corrected?
By ‘internalising’ the externality.
i.e. if a producer has a production externality of high pollution causing people nearby to develop cancer, the people can sue the producer to create a market where there was not one originally.
What is a property right?
The exclusive authority to determine how a resource is used.
How are property rights defended in modern capitalist societies?
The legal system.
How do externalities affect private property rights?
The owner of the private property cannot prevent passers-by from enjoying the view of the house.
Passers-by can free-ride despite not paying for the good.
How do externalities affect private property rights?
The owner of the private property cannot prevent passers-by from enjoying the view of the house.
Passers-by can free-ride despite not paying for the good.
What is the free-rider problem?
A free rider is someone who benefits without paying as a result of non-excludability. Customers may choose not to pay for a good, preferring instead to free ride, with the result that the incentive to provide the good through the market disappears.
What is the free-rider problem a cause of?
Market failure.
Why is the free-rider problem a cause of market failure?
There is a missing or partial missing market which means consumers / producers cannot charge for the damages (although they can in some instances) and public benefits they generate respectively.
What is a production externality?
An externality generated in the course of producing a good or service.
What is a production externality of a power station?
The power station discharges pollution into the atmosphere to produce electricity. The production externality is therefore negative. The power station evades some of the real costs of production by dumping the public bad onto others.
The price the consumer pays only reflects monetary costs of production, not all the real costs which include external costs.
In a market situation, the power’s station output of electricity is therefore underpriced. The allocative function of prices has therefore broken down.
The under-pricing of electricity encourages over-consumption of electricity, therefore leading to over-production of both electricity and pollution.
How can a power station possibly have positive production externalities?
It can be assumed that the power station generates warm and clean water, which should increase fish stocks in a nearby river.
Therefore private anglers and commercial fishing boats benefit from the power station.
As the power station cannot charge the fishermen for the warm water, as not only do they not own the river, the fishermen are not paying for the warm water which they are fishing from.
What is a consumption externality?
An externality generated in the course of consuming a good or service.
What is an example of a negative consumption externality?
Going to a cinema and being disturbed by other cinema-goers eating loudly, or talking.
What are the two types of externality?
Pure production externalities
Pure consumption externalities
How do externalities lead to the ‘wrong’ quantity of a good being produced and consumed?
If negative production externalities are gnerated, goods end up being too cheap or under-priced as the market has created the wrong incentives.
Prices under-reflect the true costs of production, including the cost of negative externalities so too much of the good end up being produced and consumed.
The opposite occurs when firms generate positive production externalities.
Prices end up being too high, so the ‘wrong’ quantity of the good is produced and consumed.
The market has created the wrong incentives, discouraging consumption.
What is the Coase theorem and where can it be applied?
An argument that if markets can be created for private property rights, government intervention to correct market failures might be not necessary.
Coase used an example of wood-burning locomotives.
A more appropriate example for the modern world would be a loud factory producing machinery. As it is a loud process, the neighbours are disturbed, but the business can pay neighbours to compensate for the noise.
The Coase theorem has greatly influenced the free-market approach to market failures. Most economists now accept that govenrments should try to work with the market rather than against the market through regulation.
Draw the graph for a negative externality?
What is the difference between the two curves in this graph called?
Marginal External Cost
Where does the power station maximise private benefit?
Where MPC = MPB
Where is the socially optimal level of output?
Where MSC = MSB
How can deadweight loss be eliminated, and why does this occur?
At a free market output of Q1, the social cost of producing one unit of electricity is greater than the benefit society derives from eaech unit produced.
Society would be better off if units between Q2 and Q1 were transferred to the production of other products.
Draw a positive production externalities graph.
