8.4 Positive And Negative Externalities In Consumption And Production

Question 1

What are externalities?

Answer 1

• An externality is the cost or benefit a third party receives from an economic
  transaction outside of the market mechanism.
• In other words, it is the spill-over effect of the production or consumption of a good or service.
• Externalities can be positive (external benefits) or negative (external costs).

Question 2

What are negative externalities?

Answer 2

• caused by the consumption of demerit goods.
• associated with information failure, since consumers are not aware of the long run
  implications of consuming the good
• they are usually overprovided by the free market
• For example, cigarettes and alcohol are demerit goods.
• The negative externality to third parties of consuming cigarettes is second-hand smoke or passive smoking.

Question 3

What are positive externalities?

Answer 3

• caused by the consumption of merit goods.
• also are associated with information failure because consumers do not realise the long run benefits to consuming the good
• They are underprovided in a free market.
• For example, education and healthcare are merit goods.
• The positive externality to third parties of education is a higher skilled workforce.

Question 4

Give an evaluation of externalities

Answer 4

• The extent to which the market fails involves a value judgement, so it is hard to determine what the monetary value of an externality is.
• For example, it is hard to decide what the cost of pollution to society is.
• Different individuals will put a different value on it, depending on their own experiences with pollution, such as how polluted their home town is.
• This makes determining government policies difficult, too.

Question 5

What are private costs?

Answer 5

• Producers are concerned with private costs of production
• For example, the rent, the cost of FoP, insurance, transport and paying for raw materials are private costs.
• This determines how much the producer will supply.
• It could refer to the market price which the consumer pays for the good.

Question 6

What are social costs?

Answer 6

• This is calculated by private costs+external costs
• In other words, external costs are the difference between private costs and
  social costs.
• It can be seen that marginal social costs and marginal private costs diverge from each other.
• External costs increase disproportionately with increased output.

Question 7

What are private benefits?

Answer 7

• Consumers are concerned with the private benefit derived from the consumption of a good.
• The price the consumer is prepared to pay determines this.
• Private benefits could also be a firm’s revenue from selling a good.

Question 8

What are social benefits?

Answer 8

• Social benefits are private benefits+external benefits.
• On a diagram, external benefits are the difference between private and social
  benefits.
• Similarly to external costs, external benefits increase disproportionately as output increases

Question 9

Where is the socially optimum position?

Answer 9

• This is 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 10

What are external costs of production?
Represent this on a diagram

Answer 10

• External costs occur when a good is being produced or consumed, such as pollution.
• They are shown by the vertical distance between MSC and MPC.
• The market equilibrium, where supply = demand at a certain price, ignores these negative externalities.
• This leads to over-provision and under-pricing.
  -With negative externalities, MSC>MPC of supply.
• The triangle in the diagram show the
  area of welfare loss

Negative externality in production shade in DWL on right hand side

Question 11

What are external benefits of production?
Draw a diagram to represent this

Answer 11

• An example of an external benefit from the production or consumption of a good or service could be the decline of diseases and the healthier lives of consumers through vaccination programmes.
• Since consumers and producers do not account for them, they are underprovided and under consumed in the free market, where MSB>MPB.
• This leads to market failure.

The triangle in the diagram can show the excess of social benefits over costs.
- It is the area of welfare gain.

Positive externality diagram-welfare gain on left hand side

Question 12

Why does the absence of property rights lead to externalities in both production and consumption and hence market failure?

Answer 12

• Markets become inefficient where there are no property rights.
• For example, it is practically impossible to establish property rights on goods such as sea water and air.
• This means that free-riders can have unlimited access, which results in the exploitation of the good.
• The 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.
• Scarce resources could be over-used or exploited.
• For example, rainforests are depleting and many species of fish are becoming endangered.
• This is because the environment cannot be protected by applying property rights.