externalities

Question 1

definition of an externality

Answer 1

an externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism – spill over of the production or consumption of a good or service

Question 2

negative externalities

Answer 2

Caused by de merit goods – associated with information failure – as consumers may not be aware of long run implications of goods – overprovided

For example cigs and alcohol

Such as second hand smoking from cigs

Question 3

positive externalities

Answer 3

Caused by merit goods – also information failure – consumers unaware of benefits of consuming good in long run – underprovided

Education and healthcare

Education leads to higher skilled workforce in long run

Question 4

private costs

Answer 4

Producers are concerned with private costs of production – such as rent – cost of machinery and labour – insurance – transport – paying for raw materials – all private costs

This determines how much the producer will supply

It could refer to the market price which consumer pay for the good

Question 5

social costs

Answer 5

= private costs + external costs

On a diagram – external costs are shown by the vertical distance between the two curves – external costs are the difference between private costs and social costs

Question 6

private benefits

Answer 6

Consumers are concerned with the private benefit derived from the consumption of a good – price consumer is prepared to pay determines this

Private benefits could also be a firms revenue from selling a good

Question 7

social benefit

Answer 7

social benefits are private benefits + external benefits

on a diagram – difference between private and social benefits

external benefits increase disproportionately as output increases

Question 8

external costs of production - diagram (6)

Answer 8

external costs occur when a good such as pollution is produced or consumed

is the vertical distance between MSC and MPC

the market equilibrium – ignores these negative externalities – leads to overprovision and under pricing

with negative externalities – MSC > MPC of supply – therefore at free market equilibrium – excess social costs over benefits at the output between Q1 and Qe

deadweight welfare loss occurs when social costs > private benefits

market fails to account for negative externality caused from consumption of good – which would reduce welfare in society if left to free market

Question 9

external benefits of production - diagram (2)

Answer 9

the decline of disease and healthier lives is an example of external benefit – through consumption of NHS – positive externalities

since consumers and producers do not account for them – underprovided – where MSB > MPB – leads to market failure

Question 10

Why the absence of property rights leads to externalities in both production and consumption = market failure (4)

Answer 10

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 – means free riders have unlimited access – results in exploitation of the good

moral hazard assumes others will pay the consequences of poor choice – such as people littering as they expect others to clean up after

scarce resources may be overused or exploited – for example rainforests are depleting – as environment cannot be protected by applying property rights