Chapter 6: Positive externalities

Question 1

When do positive externalities exist?

Answer 1

When the social benefit of a good or service is greater than the private benefit.

Question 2

Give an example of when a private action benefits a third party.

Answer 2

When an individual uses deodorant, this obviously benefits themselves but their fragrant odour also has a benefit to others.

Question 3

Give some examples of goods that exhibit positive externalities.

Answer 3

Health, education, the arts, sports, museums, pensions and libraries.

Question 4

What is the social benefit equal to?

Answer 4

Private benefit + externality = social benefit

Question 5

What area is represents the net welfare loss on a diagram for a merit good?

Answer 5

It is a triangle and its largest side is the distance between the MPB and the MSB.

Question 6

Why is there a net welfare loss for merit goods?

Answer 6

This is something we could be getting but we are not.

Question 7

What failure can government provision correct?

Answer 7

If the market system fails to provide an optimal level of goods which exhibit positive externalities i.e. merit goods.

Question 8

How can the government use subsidies to produce more merit goods?

Answer 8

The effect of a subsidy is to reduce the costs of production and so the MPC curve shifts to the right because it entices firms to produce more than they might otherwise have done.

Question 9

Give an example of legislation that encourages more use of merit goods.

Answer 9

Every child has to attend school.

Question 10

How can the government use information to encourage more usage of merit goods?

Answer 10

The government could use advertising or any other form of communication to reduce the chances of consumers making ill-informed choices.

Question 11

How can taxes be used to encourage more usage of merit goods?

Answer 11

Individuals could be offered tax relief.

Question 12

What can the absence of competition lead to?

Answer 12

Both allocative and productive inefficiency may emerge.

Question 13

What are the problems with government provision?

Answer 13

It leads to an absence of competition, government agencies may also be unresponsive to consumer preferences and administration may become bureaucratic (too caught up in following rules and procedures).

Question 14

What is a cost-benefit analysis?

Answer 14

It is an attempt to capture and assess all of the costs and benefits associated with a project.

Question 15

What are some positive externalities of construction?

Answer 15

Increased trade and employment.

Question 16

What are some negative externalities of construction?

Answer 16

Loss of countryside, the noise imposed on people living near the construction site and the prospect of someone losing their life in the process of construction.

Question 17

Why does the free market not always take into account external costs and benefits?

Answer 17

Decisions are made on the basis of private costs and private benefits alone.

Question 18

When can a project be allowed to proceed?

Answer 18

If the total benefits to society outweigh the total costs.

Question 19

List the five stages in a cost-benefit analysis?

Answer 19

1. Identify all the costs and benefits, 2. Attach a monetary value to each of the costs and benefits, 3. Work out the probability of each cost and benefit occurring, 4. Take some account of the time horizon involved, 5. Make a final decision on the basis of the final figures.

Question 20

What happens in the first stage of a cost-benefit analysis?

Answer 20

It is necessary to identify all the social costs, private costs, social benefits and private benefits.

Question 21

How can you calculate the monetary value of private costs?

Answer 21

This is the cost of all the factors of production used in the construction such as labour, capital and raw materials.

Question 22

What is the private benefit to the company?

Answer 22

The expected revenues of the completed project.

Question 23

Give an example of why monetary values of externalities are difficult to calculate.

Answer 23

It is hard to put a value on the loss of the beautiful countryside for instance.

Question 24

How can past projects be used to estimate the value of an externality?

Answer 24

You can compare the property values before and after the completion of a large project that is similar to your project to estimate the cost of noise pollution for instance or the loss of the countryside.

Question 25

How would opportunity costs be used to estimate the monetary gain of building a new road which relieved congestion?

Answer 25

You could multiply the number of hours lost owing to congestion and then multiply this by the average wage of the typical road user so that you can calculate the opportunity cost of congestion.

Question 26

How can surveys be used to quantify the value of an external cost or benefit?

Answer 26

Surveys can ask people how much they would be willing to pay to preserve something or how much they would need in compensation for the loss of something.

Question 27

What happens in stage three of a cost-benefit analysis?

Answer 27

The values of all the variables are multiplied by the probability of their occurrence.

Question 28

Why is it important to take into account a time horizon?

Answer 28

The expected revenues and costs may change overtime.

Question 29

When are some projects viable?

Answer 29

If a long enough time horizon is used.

Question 30

What is another factor that has to be considered in a CBA in terms of the rate of return?

Answer 30

Another factor that has to be considered is the rate of return that might have been gained if the money for the project had simply been invested.

Question 31

Why is it important when doing the rate of returns calculation to have some idea of future interest rates?

Answer 31

The future path of interest rates is very uncertain.

Question 32

What is a way in which you can avoid the problem of interest rates changing in the future?

Answer 32

Doing a series of interest rate calculations based on different interest rate scenarios.

Question 33

What else can have a bearing on the final decision based on a CBA?

Answer 33

Whether a project proceeds or not is determined by politicians so political factors also have an effect on the final decision.

Question 34

Why is a CBA better than a private investment appraisal?

Answer 34

It takes some account of positive and negative externalities.

Question 35

Why does a CBA take a long view and a wide view?

Answer 35

It assesses costs and benefits over a long period of time and it tries to capture social costs as well as private costs.

Question 36

What is a limitation of using past projects to estimate monetary values?

Answer 36

The extent to which any two projects are similar will have some bearing on the usefulness of past projects.

Question 37

What is the limitation of using opportunity costs to estimate monetary values?

Answer 37

It uses averages and averages mask inequalities.

Question 38

What is the limitation of using surveys to estimate monetary values?

Answer 38

Sometimes people are confused or misunderstand the issues involved. Also, prompted by greed, people overestimate or exaggerate about how much they value external benefits in order to get more compensation.

Question 39

What are the benefits of a CBA?

Answer 39

It makes some attempt to value external costs and benefits and gives values to resources such as the environment which would otherwise be valued at zero by the free market.