4.1.8.4 - Positive and Negative Externalities in Consumption and Production Flashcards
What are externalities?
A public good or bad ‘dumped’ on third parties outside the market.
When do externalities exist?
When there is a divergence between private and social costs or benefits.
What type of good is an externality?
A public good.
Why is an externality a special type of good?
It is imposed on third parties who are forced to consume it, whether they want it or not.
What is a positive externality?
An external benefit when consumption causes costs to a third party, where social cost is greater than private cost.
What is a negative externality?
When consumption or production causes costs to a third party, where social cost is greater than private cost.
How can negative externalities be corrected?
By ‘internalizing’ the externality (e.g., suing for pollution).
What is a property right?
The exclusive authority to determine how a resource is used.
How are property rights defended in modern capitalist societies?
Through the legal system.
How do externalities affect private property rights?
Owners can’t prevent others from enjoying the benefit of their property, leading to free-riders.
What is the free-rider problem?
A situation where people benefit without paying because of non-excludability.
What is the free-rider problem a cause of?
Market failure.
Why is the free-rider problem a cause of market failure?
It creates a missing or partial market, meaning producers can’t charge for damages or public benefits.
What is a production externality?
An externality generated during the production of a good or service.
What is a production externality of a power station?
Pollution from electricity production, a negative externality. The price reflects only private costs, underpricing the good.
How can a power station have positive production externalities?
By generating warm water, benefiting nearby fish stocks.
What is a consumption externality?
An externality generated during the consumption of a good or service.
What is an example of a negative consumption externality?
Being disturbed by loud cinema-goers.
What are the two types of externality?
Pure production externalities and pure consumption externalities.
How do externalities lead to the ‘wrong’ quantity of a good being produced and consumed?
Negative externalities lead to underpricing and overproduction, while positive externalities lead to overpricing and underproduction.
What is the Coase theorem and where can it be applied?
It argues that market solutions can address externalities without government intervention if property rights are well-defined (e.g., paying neighbors for noise).
What do critics of private property rights tend to want?
The transfer of private property rights to government or common ownership.
What is the ‘tragedy of the commons’?
A situation where individuals’ actions harm the common good, leading to overuse or depletion of shared resources.
What can the ‘tragedy of the commons’ lead to?
Overuse of common-pool resources, resulting in unsustainable use.
What is a recent example of the ‘tragedy of the commons’?
Overfishing leading to a reduction in fish stocks.
What are the main types of environmental externalities?
Pollution (land, sea, rivers, air), road congestion, sulfur dioxide emissions.
How are governments attempting to reduce environmental market failures?
By increasing behavioral nudges, such as reducing plastic dumping.
What is the main assumption about economic agents?
They consider only private costs and benefits, ignoring social costs and benefits.
When does private benefit maximization occur?
When Marginal Private Benefit (MPB) = Marginal Private Cost (MPC).
When does social benefit maximization occur?
When Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).
What is social benefit maximization?
When the public interest or welfare is maximized.
What does orthodox economic theory assume about households?
They seek to maximize their private benefit, ignoring wider community impact.
Why doesn’t net social benefit coincide with net private benefit?
Because households only maximize private benefit, generating externalities that cause divergence between the two.
What is social benefit defined as (equation)?
MSB = MPB + MEB (Marginal External Benefit).
What is social cost defined as (equation)?
MSC = MPC + MEC (Marginal External Cost).
Where does a power station maximize private benefit?
Where MPC = MPB.
Where is the socially optimal level of output?
Where MSC = MSB.
How can deadweight loss be eliminated?
By reducing overproduction from negative externalities and shifting resources to more beneficial outputs.
Why are there positive production externalities associated with planting trees?
Trees improve water retention, act as a carbon sink, and benefit surrounding ecosystems.
What does the vertical distance between MPC and MSC mean in positive production externalities?
A marginal external benefit at each level of tree planting.
Why should deadweight loss be eliminated in positive production externalities?
Because MSB exceeds MPC until the socially optimal production point (MSB = MSC).
When can allocative efficiency occur?
In competitive markets with no externalities (negative or positive), where P = MC.
Why can allocative efficiency never really occur?
It’s an abstract concept, and externalities complicate real-world markets.
Where does profit maximization occur in the long run according to externalities?
Where P = MPC. Externalities cause MSC > MPC, leading to underpricing and inefficiency.
When do externalities exist?
When there is a divergence between private and social costs or benefits.
What is the key feature of externalities?
There is no market where they can be bought or sold.
Where are externalities produced and received relative to the market?
Outside the market (a missing market).
What do externalities divide into?
Production externalities and consumption externalities.
What effect do externalities have on production and consumption?
They cause the wrong quantity to be produced and consumed.
What happens to prices and consumption in negative production externalities?
Prices are too low, and too much of the good is produced and consumed.
What happens to prices and consumption in positive production externalities?
Prices are too high, and not enough of the good is produced and consumed.
