Externalities Flashcards
Externalities
-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).
-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. 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.
Private costs
-Are the costs to economic agents involved directly in an economic transaction.
-Producers are concerned with private costs of production, for example rent, cost of machinery and labour, 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.
Social costs
-This is calculated by private costs plus external costs. It is the cost to society as a whole.
-On a diagram, external costs are shown by the vertical distance between the two curves-distance between private and social costs.
-It can be seen that marginal social costs (MSC) and marginal private costs (MPC) diverge from each other. External costs increase disproportionally with increased output.
Private benefit
-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 firms revenue from selling a good.
Social benefit
-Social benefits are private benefits plus external benefits.
-On a diagram, external benefits are the difference between private and social benefits.
-similarly to external costs, external benefits increase disproportionally as output increases.
Social optimum position
-This is where MSC=MSB and is the point of maximum welfare.
-The social cost made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output.
External costs of production
https://edexceleconomicsrevision.com/home/theme-1-introduction-to-markets-and-market-faliure/externalities/
-External costs occur when a good is being produced or consumed, such as pollution.
-Shown by vertical distance between MSC and MPC.
-The market equilibrium, where supply=demand at a certain price, ignores these negative externalities.
-This leads to overprovision and underpricing.
-With negative externalities, MSC>MPC of supply. At the free market equilibrium, therefore, there are an excess of social costs over benefits at the output between Q1 and Qe.
-The output where social costs>private benefits is known as the area of deadweight welfare loss, shown by the triangle in the diagram.
External benefits of consumption
https://edexceleconomicsrevision.com/home/theme-1-introduction-to-markets-and-market-faliure/externalities/
-An example of an external benefit of consumption of a good or service could be the decline of diseases and the healthier lives of consumers through vaccination programmes.
-Since consumers don’t account for them, they are under consumed in the free market, where MSB>MPB. This leads to market failure.
-The triangle in the diagram shows the excess of social benefits over costs. It is the area of welfare gain.
Government policies for negative externalities
-Indirect taxes:To reduce the quantity of demerit goods consumed. This increases the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium. This internalises the externality. In other words, the polluter pays for the damage.
-Subsidies:encourage the consumption of merit goods. This includes the full social benefit in the market price of the good.
-Regulation:To enforce less consumption of a good. For example, the minimum school leaving age. If there was a compulsory recycling scheme, it would be difficult to police and there could be high administrative costs. Bans could be enforced for harmful goods, although they can still be consumed on the black market. Bans are only useful where MSC>MPB (the MSC curve is above MPB)
