4.1.8.4 Positive and negative externalities in consumption and production

Question 1

When do externalities exist ?

Answer 1

when there is a divergence between private and social costs and benefit

Question 2

Why are negative externalities likely to result in over-production ?

Answer 2

Negative externalities are caused by demerit goods. These are associated with information failure, since consumers are not aware of the long run implications of consuming the good, and they are usually overprovided.

Question 3

Why are positive externalities likely to result in under-production ?

Answer 3

Positive externalities are caused by merit goods. These are associated with information failure too, because consumers do not realise the long run benefits to consuming the good. They are underprovided in a free market.

Question 4

Production externality

Answer 4

an externality generated in the course of producing a good or service

Question 5

Consumption externality

Answer 5

an externality generated in the course of consuming a good or service

Question 6

social benefits

Answer 6

the total benefit of a particular action. Private benefit + external benefit.

Question 7

Private benefit

Answer 7

those benefits that are incurred by individuals who produce or consume a good or service

Question 8

Social costs

Answer 8

the total cost of a particular action.

Private cost + external cost.

Question 9

Private costs

Answer 9

those costs that are incurred by individuals who produce or consume a good or service.

Question 10

Social optimum position: iwhere

Answer 10

where MSC = MSB and it is the point of maximum welfare.

The social costs made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output.

Question 11

When do markets become inefficient?

Answer 11

When there is no property rights

Question 12

What does the moral hazard assume ?

Answer 12

moral hazard assumes someone else will pay the consequences for a poor choice.

For example, some people might litter the street if they think that other people will clear up after them

Question 13

Dealing with positive externalities

Answer 13

Rules and regulations – minimum school leaving age

Increasing supply – the government building of council housing to increase the stock of good quality housing.

Subsidy to reduce price and encourage consumption, e.g. government subsidy for rural train services.

Question 14

Externality of the housing market

Answer 14

Therefore, the social benefit of good quality housing can be greater than the private benefit that property developers gain.

Question 15

Positive externality in the housing market: social problems

Answer 15

Good quality housing helps to reduce social problems, such as drug use, crime and vandalism. Poor quality, high-density housing (e.g. 1960s tower blocks) were associated with various social problems, such as increased crime rates. This type of housing may be cheap to build, but investing in better quality housing with more features, such as gardens can create a better environment which helps to improve social welfare and strengthen local communities.

Question 16

Positive externality in the housing market: public health

Answer 16

Better public health. In extreme cases ‘slum’ housing with poor sanitation and damp surroundings can contribute to ill health. Building better housing without damp and with better sanitation can lead to improved public health which is an external benefit to society.

Question 17

Positive externality in the housing market: environmental standards

Answer 17

If houses are built with high levels of insulation, then they will help reduce the environmental costs of heating. This is an external benefit because society benefits from an improved environment related to the building of insulated housing.

Question 18

Positive externality in the housing market: mobility

Answer 18

Building new houses can also increase geographical mobility and provide benefits to local business and employers struggling to employ sufficient people.

Question 19

Market failures in housing

Answer 19

Homelessness – but empty housing

Expensive cost of housing and inequality.

Geographical immobility (regional difference in house prices)

Boom and bust in house prices and effect on macroeconomy

Housing as merit good – social problems (crime and vandalism) arising from lack of sufficiently good quality housing.

Environmental costs of building new houses.

Question 20

Geographical immobility in the housing market

Answer 20

Due to the divergence between house prices in the north and south, it can be difficult for workers to find suitable accommodation in London. Therefore, this leads to a shortage of key skilled workers in areas of very expensive house prices. For example, London schools and hospitals are experiencing staff shortages – partly caused by the housing market.
It is difficult for firms to relocate and it is difficult to build houses in the expensive cities.

Question 21

Merit good in the housing market

Answer 21

Housing could also be seen as a type of merit good with positive externalities for the rest of society. If housing is of a poor standard (e.g. overcrowding, unsanitary conditions) it can contribute to social problems such as rioting, crime, unemployment and vandalism. Well maintained housing provides conditions more amenable to reducing these social problems.

Question 22

Negative externalities

Answer 22

Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party.

Question 23

Examples of negative externalities

Answer 23

Loud music. If you play loud music at night, your neighbour may not be able to sleep.
Pollution. If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.
Congestion. If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.
Building a new road. If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.

Question 24

Negative production externality

Answer 24

When producing a good causes a harmful effect to a third party. Therefore the social cost is greater than the private cost

Question 25

Examples of negative production externalities

Answer 25

Burning coal for energy creates pollution.
Producing conventional vegetables with pesticides causes carcinogens to get into the environment.
Producing beef in South America involves cutting down Amazon rainforest, which has an impact on global climate and local environment

Question 26

Negative externality of consumption

Answer 26

This occurs when consuming a good causes a harmful effect to a third party. In this case, the social benefit is less than the private benefit.

Question 27

Examples of negative externalities of consumption

Answer 27

Consuming alcohol leads to an increase in drunkenness, increased risk of car accidents and social disorder.
Consuming loud music late at night keeps your neighbours awake.
Consuming cigarettes causes passive smoking to others in the vacinity.