Correcting Positive Externalities

Question 1

What is the goal of policies aiming to correct positive externalities?

Answer 1

The goal of policies aiming to correct positive externalities is to increase supply (and demand) of that good or service

Question 2

What are the 3 government policies to correct positive externalities?

Answer 2

1. Direct government provision
2. Subsidies
3. Legislation & Advertising (only for consumption externalities)

Question 3

What is the impact of direct government provision in correcting positive production externalities?

Answer 3

Direct provision of the good/service (such as R&D) has the effect of increasing the supply curve (MPC shifts towards MSC), thereby eliminating the externality

Question 4

What is the impact of direct government provision in correcting positive consumption externalities?

Answer 4

Direct provision has the effect of increasing supply, thereby MSC shifts rightward to MPC + government provision. This results in MPC intersecting MPB at the socially optimum quantity (but a lower price).

Question 5

What are the 3 advantages of direct provision?

Answer 5

1. Simple to implement and is highly effective in increasing the quantity produced and consumed
2. Lowers the price for consumers
3. Large economies of scale, leading to productive efficiency (in the case of healthcare or education)

Question 6

What are the 5 disadvantages of direct provision?

Answer 6

1. Without competition, direct provision can create inefficient bureaucratic organizations (undesirable situation of state monopoly)
2. No consumer choice and leads to higher costs (according to market-oriented economists)
3. Opportunity cost of using government funds
4. Difficulty to choose what good/service should be supported
5. Political bias

Question 7

What are subsidies?

Answer 7

Payments made from the government to individuals or firms for the production or consumption of particular goods or services

Question 8

What is the impact of subsidies in correcting positive production externalities?

Answer 8

It reduces the costs of production and thereby increases supply, causing MPC to shift towards MSC and removing externality (assuming subsidy amount equals externality)

Question 9

What is the impact of subsidies in correcting positive consumption externalities?

Answer 9

It reduces the costs of production and thereby increases supply, causing MSC to shift to the right MPC + subsidies. The new equilibrium is produced at the socially optimum quantity but at a lower price.

Question 10

What are the 3 advantages of subsidies?

Answer 10

1. Simple to implement and is highly effective in increasing the quantity produced and consumed
2. Lowers the price for consumers
3. It can be argued that subsidies also have the effect of reducing negative externalities (example: subsidizing public transport)

Question 11

What are the 5 disadvantages of subsidies

Answer 11

1. Difficulties in measuring the value of external benefits
2. Opportunity costs for using government funds
3. Difficulties in determining what should be subsidized
4. May encourage firms to be inefficient and rely on the subsidy
5. Political bias

Question 12

What is the impact of legislation and advertisement in correcting positive consumption externalities?

Answer 12

Example for legislation: education compulsory
Example for advertisement: safe-sex advertisements

In both cases, demand for education increases and demand curve shifts from MPB to MSB

Question 13

What are the 2 advantages of legislation and advertising?

Answer 13

1. Simple to implement

2. Effective at least partially, especially in the case of laws making education compuslory

Question 14

What are the 4 disadvantages of legislation and advertising?

Answer 14

1. Advertising and legislation alone are unlikely to increase demand to the required level
2. Opportunity costs
3. Difficulties of compliance and enforcement of legislation
4. Leads to increase in price of product