4.1.8.4 - Positive and Negative Externalities in Consumption and Production

Question 1

What are externalities?

Answer 1

A public good or bad ‘dumped’ on third parties outside the market.

Question 2

When do externalities exist?

Answer 2

When there is a divergence between private and social costs or benefits.

Question 3

What type of good is an externality?

Answer 3

A public good.

Question 4

Why is an externality a special type of good?

Answer 4

It is imposed on third parties who are forced to consume it, whether they want it or not.

Question 5

What is a positive externality?

Answer 5

An external benefit when consumption causes costs to a third party, where social cost is greater than private cost.

Question 6

What is a negative externality?

Answer 6

When consumption or production causes costs to a third party, where social cost is greater than private cost.

Question 7

How can negative externalities be corrected?

Answer 7

By ‘internalizing’ the externality (e.g., suing for pollution).

Question 8

What is a property right?

Answer 8

The exclusive authority to determine how a resource is used.

Question 9

How are property rights defended in modern capitalist societies?

Answer 9

Through the legal system.

Question 10

How do externalities affect private property rights?

Answer 10

Owners can’t prevent others from enjoying the benefit of their property, leading to free-riders.

Question 11

What is the free-rider problem?

Answer 11

A situation where people benefit without paying because of non-excludability.

Question 12

What is the free-rider problem a cause of?

Answer 12

Market failure.

Question 13

Why is the free-rider problem a cause of market failure?

Answer 13

It creates a missing or partial market, meaning producers can’t charge for damages or public benefits.

Question 14

What is a production externality?

Answer 14

An externality generated during the production of a good or service.

Question 15

What is a production externality of a power station?

Answer 15

Pollution from electricity production, a negative externality. The price reflects only private costs, underpricing the good.

Question 16

How can a power station have positive production externalities?

Answer 16

By generating warm water, benefiting nearby fish stocks.

Question 17

What is a consumption externality?

Answer 17

An externality generated during the consumption of a good or service.

Question 18

What is an example of a negative consumption externality?

Answer 18

Being disturbed by loud cinema-goers.

Question 19

What are the two types of externality?

Answer 19

Pure production externalities and pure consumption externalities.

Question 20

How do externalities lead to the ‘wrong’ quantity of a good being produced and consumed?

Answer 20

Negative externalities lead to underpricing and overproduction, while positive externalities lead to overpricing and underproduction.

Question 21

What is the Coase theorem and where can it be applied?

Answer 21

It argues that market solutions can address externalities without government intervention if property rights are well-defined (e.g., paying neighbors for noise).

Question 22

What do critics of private property rights tend to want?

Answer 22

The transfer of private property rights to government or common ownership.

Question 23

What is the ‘tragedy of the commons’?

Answer 23

A situation where individuals’ actions harm the common good, leading to overuse or depletion of shared resources.

Question 24

What can the ‘tragedy of the commons’ lead to?

Answer 24

Overuse of common-pool resources, resulting in unsustainable use.

Question 25

What is a recent example of the ‘tragedy of the commons’?

Answer 25

Overfishing leading to a reduction in fish stocks.

Question 26

What are the main types of environmental externalities?

Answer 26

Pollution (land, sea, rivers, air), road congestion, sulfur dioxide emissions.

Question 27

How are governments attempting to reduce environmental market failures?

Answer 27

By increasing behavioral nudges, such as reducing plastic dumping.

Question 28

What is the main assumption about economic agents?

Answer 28

They consider only private costs and benefits, ignoring social costs and benefits.

Question 29

When does private benefit maximization occur?

Answer 29

When Marginal Private Benefit (MPB) = Marginal Private Cost (MPC).

Question 30

When does social benefit maximization occur?

Answer 30

When Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).

Question 31

What is social benefit maximization?

Answer 31

When the public interest or welfare is maximized.

Question 32

What does orthodox economic theory assume about households?

Answer 32

They seek to maximize their private benefit, ignoring wider community impact.

Question 33

Why doesn’t net social benefit coincide with net private benefit?

Answer 33

Because households only maximize private benefit, generating externalities that cause divergence between the two.

Question 34

What is social benefit defined as (equation)?

Answer 34

MSB = MPB + MEB (Marginal External Benefit).

Question 35

What is social cost defined as (equation)?

Answer 35

MSC = MPC + MEC (Marginal External Cost).

Question 36

Where does a power station maximize private benefit?

Answer 36

Where MPC = MPB.

Question 37

Where is the socially optimal level of output?

Answer 37

Where MSC = MSB.

Question 38

How can deadweight loss be eliminated?

Answer 38

By reducing overproduction from negative externalities and shifting resources to more beneficial outputs.

Question 39

Why are there positive production externalities associated with planting trees?

Answer 39

Trees improve water retention, act as a carbon sink, and benefit surrounding ecosystems.

Question 40

What does the vertical distance between MPC and MSC mean in positive production externalities?

Answer 40

A marginal external benefit at each level of tree planting.

Question 41

Why should deadweight loss be eliminated in positive production externalities?

Answer 41

Because MSB exceeds MPC until the socially optimal production point (MSB = MSC).

Question 42

When can allocative efficiency occur?

Answer 42

In competitive markets with no externalities (negative or positive), where P = MC.

Question 43

Why can allocative efficiency never really occur?

Answer 43

It’s an abstract concept, and externalities complicate real-world markets.

Question 44

Where does profit maximization occur in the long run according to externalities?

Answer 44

Where P = MPC. Externalities cause MSC > MPC, leading to underpricing and inefficiency.

Question 45

When do externalities exist?

Answer 45

When there is a divergence between private and social costs or benefits.

Question 46

What is the key feature of externalities?

Answer 46

There is no market where they can be bought or sold.

Question 47

Where are externalities produced and received relative to the market?

Answer 47

Outside the market (a missing market).

Question 48

What do externalities divide into?

Answer 48

Production externalities and consumption externalities.

Question 49

What effect do externalities have on production and consumption?

Answer 49

They cause the wrong quantity to be produced and consumed.

Question 50

What happens to prices and consumption in negative production externalities?

Answer 50

Prices are too low, and too much of the good is produced and consumed.

Question 51

What happens to prices and consumption in positive production externalities?

Answer 51

Prices are too high, and not enough of the good is produced and consumed.