Externalities

Question 1

What is the definition of an externality?

Answer 1

An externality is a cost or benefit of an economic activity experienced by third parties (those not directly involved in the activity). It can be a public good (positive externality) or a public bad (negative externality).

Question 2

Who are third parties in the context of externalities?

Answer 2

Third parties are individuals or entities who do not directly participate in the transaction but are affected by the activity.

Question 3

What is a spin-off effect in economics?

Answer 3

A spin-off effect refers to externalities being side effects of production or consumption that affect others.

Question 4

What are negative externalities?

Answer 4

Negative externalities occur when the production or consumption of a good or service results in harmful effects for third parties, such as pollution from factories or road congestion caused by excessive traffic.

Question 5

What is the market failure associated with negative externalities?

Answer 5

Market failure occurs due to overproduction and underpricing of the good or service.

Question 6

What are positive externalities?

Answer 6

Positive externalities occur when the production or consumption of a good or service results in beneficial effects for third parties, such as pollination of fruit trees by bees or vaccination programs that reduce disease transmission in the community.

Question 7

What is the market failure associated with positive externalities?

Answer 7

Market failure occurs due to underproduction, as producers or consumers do not capture the full benefits of their actions.

Question 8

What are production externalities?

Answer 8

Production externalities arise during the production process, where firms’ activities affect other parties, such as a factory emitting pollution.

Question 9

What are consumption externalities?

Answer 9

Consumption externalities arise from individual consumption decisions that affect others, such as smoking in public places affecting others’ health.

Question 10

What is a marginal private benefit (MPB)?

Answer 10

MPB is the benefit received by the individual or firm engaging in an economic activity.

Question 11

What is a marginal external benefit (MEB)?

Answer 11

MEB is the additional benefit received by third parties that are not reflected in the decision-making of the individual or firm.

Question 12

What is a marginal social benefit (MSB)?

Answer 12

MSB is the total benefit to society, combining private benefits and external benefits. MSB = MPB + MEB.

Question 13

What is a marginal private cost (MPC)?

Answer 13

MPC is the cost borne by the individual or firm engaging in the economic activity.

Question 14

What is a marginal external cost (MEC)?

Answer 14

MEC is the additional cost borne by third parties due to the economic activity.

Question 15

What is a marginal social cost (MSC)?

Answer 15

MSC is the total cost to society, combining private costs and external costs. MSC = MPC + MEC.

Question 16

What is allocative efficiency?

Answer 16

Allocative efficiency is achieved when the price equals the marginal cost of production (P = MC) and the marginal social cost equals the marginal social benefit (MSC = MSB).

Question 17

How do negative externalities lead to market failure?

Answer 17

Negative externalities cause firms to overproduce, leading to a price lower than the socially optimal price, where the marginal social cost exceeds the marginal private cost, resulting in a deadweight loss (DWL).

Question 18

How do positive externalities lead to market failure?

Answer 18

Positive externalities lead to underproduction, as producers or consumers do not capture the full benefits, and the socially optimal output is higher than the private output.

Question 19

What is the welfare gain associated with positive externalities?

Answer 19

The welfare gain is produced by increasing the good’s output between Q1 and Q2, as the marginal social benefit exceeds the marginal social cost.

Question 20

In the case of negative production externalities, what is the market equilibrium?

Answer 20

At Q1, where MPC = MPB, the market overproduces. The social optimum is at Q2, where MSC = MSB, which is lower than the market output, resulting in a deadweight loss.

Question 21

In the case of positive production externalities, what is the market equilibrium?

Answer 21

At Q1, where MPC = MPB, the market underproduces. The social optimum is at Q2, where MSC = MSB, which is higher than the market output, leading to a welfare gain.

Question 22

What is a Pigovian tax?

Answer 22

A Pigovian tax is a tax imposed on the producer to reflect the social cost of negative externalities, such as a carbon tax for pollution.

Question 23

How can regulation help address negative externalities?

Answer 23

Regulation can involve legal limits on pollution or resource use to reduce the negative impact of externalities.

Question 24

What are market-based solutions for correcting negative externalities?

Answer 24

Market-based solutions include tradable pollution permits that create incentives for firms to reduce external costs.

Question 25

How can subsidies correct positive externalities?

Answer 25

Subsidies are financial assistance to encourage the production or consumption of goods with positive externalities, such as subsidies for vaccinations or education.

Question 26

What is public provision?

Answer 26

Public provision refers to government provision of goods or services that have positive externalities, like public parks or public health initiatives.

Question 27

What is road pricing?

Answer 27

Road pricing involves charging for using roads to address negative consumption and production externalities, such as congestion.

Question 28

What is congestion pricing?

Answer 28

Congestion pricing reduces road use during peak periods, addressing negative externalities by aligning private and social costs.

Question 29

When do externalities not occur in road use?

Answer 29

Externalities do not occur when traffic flow is below a threshold, such as in uncongested roads.

Question 30

What happens when roads become congested?

Answer 30

When roads become congested, traffic congestion causes negative externalities where MSC > MPC, justifying road pricing.

Question 31

How do externalities affect market outcomes?

Answer 31

Externalities cause market failures: negative externalities lead to overproduction and underpricing, while positive externalities lead to underproduction and under-consumption.

Question 32

How can government intervention correct externalities?

Answer 32

Government intervention can use taxes, subsidies, or regulation to correct externalities and achieve allocative efficiency, where social costs and benefits are fully considered.