Externalities Flashcards
What is an externality?
Externalities are a third source of market failure that can reduce efficiency in the allocation of resources, and hence society’s wellbeing. They represent extra costs of benefits for third parties (someone not directly involved in the particular transaction) that may arise when goods and services are produced or consumed.
What is an externality? II
An externality is a cost (or benefit) that is suffered/gained by a third party resultant of an economic transactions. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organisation, property owner, or resource that is indirectly affected. There are two main types of externalities: consumption and production.
Externalities occur when production and/or consumption impose external costs or benefits on third parties outside of the market for which no appropriate compensation is accrued.
Negative Externality
Negative externalities are costs paid or borne by third parties arising from the production or consumption of a good or service.
Examples:
- when a factory producing chemicals releases unpleasant odours that we are forced to breathe, even though we do not use that firm’s products
- the smoking of cigarettes costs third parties in the form of health issues from passive smoking, and the burden on public hospitals and taxpayers who foot the bill from the consumption of tobacco, rather than the tobacco companies
Negative Externality
These costs are not paid for the producers who have created the damage. The costs of the damage for them will be zero, thereby inflating their profits. This problem distorts the efficient allocation of resources. Socially undesirable goods and services will be over-produced. Negative externalities lead to a misallocation of resources that represent market failures because they lower society’s general wellbeing and living standards.
Positive Externality
Sometimes there are benefits received by third parties that arise from the production and consumption of particular goods or services. For instance, the provision of education and health are good examples of services whose provision and consumption results in positive externalities or wider social benefits for society, improving our general wellbeing.
Positive Externality
Positives externalities result in the under-allocation of resources and the underproduction of socially beneficial goods or services since decision makers do not factor in the full value of all the benefits or satisfaction gained from a given economic activity.
Again market failure has occurred because resources are not allocated efficiently in sufficient quantites and our general wellbeing will be lower than it could be.
Private and Social Costs
The existence of externalities creates a divergence between private costs and social costs of production and the private and social benefits of consumption.
Social Cost = External Cost + Private Cost
Social Benefit = External Benefit + Private Benefit
When negative production externalities exist, social cost exceeds social benefit. This leads to overproduction if producers do not take into account the externalities.
Negative Production Externality
In the absence of externalities, the private marginal costs of the supplier are the same for the costs of society. In the presence of negative externalities, we must add the external costs to the firm’s supply curve to find the social marginal cost curve. If the market fails to include these external costs, then the private equilibrium output will be where private marginal cost = private marginal benefit.
We want less output from activities that create these negative externalities, so a socially-efficient output would be Q2 with a higher price of P2. The externality has not been eliminated - but at least the market has recognised them and priced them into the price of the product. These increase in price of product will drive consumers away from buying this product.
What is a deadweight loss?
It is the loss of economic efficiency in terms of utility for consumers/producers such that the optimal or allocative efficiency is not achieved, due to supply and demand being in a state of disequilibrium. These lead to the price of a product not being accurately reflected. If a price of a product is not reflected accurately, this leads to changes in consumer and producer and behaviour, which usually has a negative impact on the economy.
Negative Production Externality
An external cost, such as the cost of pollution from industrial production, makes the marginal social cost (MSC) curve higher than the private marginal cost (MPC). The socially efficient output is where MSC = MSB.
What is net welfare loss?
Net welfare loss can exist in two situations:
- It exists when the marginal cost to society of a particular economic activity, is greater than the marginal benefit to society.
- Secondly, it can exist when the marginal benefit of a given economic activity, is greater than the marginal cost.
Negative Consumption Externalities
When certain goods are consumed, such as demerit goods, negative effects can arise on third parties. Examples include smoking, drinking and noise pollution. For example, if an individual plays very loud music in their house they are likely to reduce the benefit to their neighbours of owning the house and living in it. Another important example of a negative consumption externality if that of road congestion; as individuals ‘consume’ road-space they reduce available road-space and deny this space to others.
Remedies to Externalities
Market-based solutions try to manipulate market forces to reduce the externality, by exploiting the price mechanism. One such market-based solutions is to extend property rights so that third parties can negotiate with those individuals or organisations that cause the externality. As long as one party can establish a property right, there will be a bargaining process leading to an agreement in which externalities are taken into account. If property rights can’t be established we must: learn to live with externalities or government intervenes on our behalf through taxes/direct controls and regulations.
Production Externalities SUMMARY
Positive Production Externality (MSC>MPC): where a firm’s production increases the wellbeing of others, but the firm is not compensated by those others. Examples include beehives established by honey producers increasing agricultural production through pollination and research and development by companies that leads to introduction of new technologies that other companies can benefit from.
Negative Production Externality (MSC>MPC): where a firm’s decision to produce decreases the wellbeing of others, but the firm does not compensate those others. Examples include air and noise pollution, dumping of waste and effect of deforestration.
Consumption Externalities SUMMARY
Positive Consumption Externalities (MSB>MPB): where an individual’s consumption increases the wellbeing of others, but the individual is not compensated by those others. Examples include vaccination, education and creating a beautiful garden that others enjoy.
Negative Consumption Externality (MSB>MPB): where an individual’s consumption decreases the wellbeing of others, but the individual does not compensate those others. Examples include excessive drinking of alcohol, smoking, obesity, motor vehicle pollution and using a noisy motorcycle.
