Private Costs And Benefits, Externalities, And Social Costs And Benefits

Question 1

Private costs

Answer 1

Expenditure incurred by producers in using resources to produce goods or services.

Question 2

External costs

Answer 2

Those costs incurred and paid for by third parties not involved in the action.

Question 3

Social costs

Answer 3

Total costs of a particular action.

Formula: Social costs 🟰 Private costs ➕External costs

Question 4

Private benefits

Answer 4

Monetary gain or other forms of benefits that an individual or producer receives from consuming or producing goods or services.

Question 5

External benefits

Answer 5

Benefits that are received by third parties that are not involved in the transaction.

Question 6

Social benefits

Answer 6

Total benefits arising from a particular action.

Total benefits to society from producing or consuming goods or services.

Formula: Social benefits 🟰 Private benefits ➕External benefits

Question 7

Marginal social cost

Answer 7

Marginal Private Cost ➕Marginal External Cost

Question 8

Marginal social benefit

Answer 8

Marginal Private Benefit ➕ Marginal External Benefit

Question 9

Externalities / Spillover effects

Answer 9

Actions of producers or consumers give rise to side effects on third parties who are not involved in the actions.

Question 10

Negative externality

Answer 10

Production or consumption of a good or service that results in a cost to a third party.

Question 11

Positive externality

Answer 11

Production or consumption of a good or service that creates a benefit to a third party.

Question 12

Negative production externalities

Answer 12

Negative externality arises from production activity because there are additional costs imposed on the community and authority that need to clean up the mess while there are little or no costs to the polluting firm.

Example, environmental pollution due to factories’ production.

Question 13

Graph for negative production externalities

Answer 13

X-axis: Quantity
Y-axis: Costs and benefits

MEC (start from 0)
S = MPC (start from 0)
MSC = MPC + MEC (start from 0)
D = MPB = MSB

Deadweight welfare loss - between MSC and S=MPC

Analysis of graph
1. MEC increase as output increase
2. No consumption externalities so the demand curve, D, for the firm’s products is downward sloping
3. Socially optimal output, Q is where MSB equals MSC
4. Actual output, Q1 is produced where MPC equals MPB
5. Deadweight welfare loss due to overproduction

Quantity increases due to asymmetric information. Consumers are unaware of the cost to the environment hence they over consume the goods, typically demerit goods.

1. Assume no consumption externalities, MPB = MSB
2. MPC upward sloping
3. Free market equilibrium is at MPC = MPB
4. As there is negative production externalities, MSC > MPC
5. Gap between MSC and MPC is MEC
6. Socially optimum output is at MSC = MSB
7. There is over production - misallocation of resources
8. MSC > MPB causes social welfare to fall

https://www.youtube.com/watch?v=xK9B1CowKlI

Question 14

Positive production externalities

Answer 14

Benefits that their parties enjoy that are created by producers of goods and services.

Example, medical research, development of new drugs or vaccines to combat certain diseases.

Question 15

Graph of positive production externalities

Answer 15

X-axis: Quantity
Y-axis: Costs and benefits

MSC = MPC - MEB
S = MPC
D = MPB = MSB
MEB

Analysis of graph
1. Given the positive externalities, MSC is now below MPC
2. Assuming no consumption externalities, MSB 🟰 MPB
3. Socially efficient level of output is at Q where MSB 🟰 MSC
4. External benefits result in a level of output below the socially efficient level
5. There is an underproduction at Q1
6. Deadweight welfare loss is between S=MPC and MSC=MPC-MEB

Quantity decreases due to asymmetric information. Consumers and producers are unaware of the consumptions or productions of the goods that bring benefits hence the goods are under consumed, typically merit goods.

1. Assume no consumption externalities, MPB = MSB.
2. Because there are positive externalities in production, MSC of production < MPC of production
3. Negative external cost is between MPC and MSC (production brings cost down to the third party in the economy)
4. Social benefit at MPC = MPB = MSB
5. Social cost at MSC under social benefit
6. Social optimum at MSB = MSC
7. Under production - misapplication of scarce resources

Exam tips:
1. Positive production externalities often associated with the benefits that come from increased spending in infrastructure including transport and telecoms networks that help to relieve congestion, speed up logistics operations, lower supply costs for many businesses and also improve the quality of service.
2. Link to wider benefits of supply-side policies designed to increase LRAS.
3. A growing number of firms have environmental sustainability as a key objective and are prepared to cooperate in joint research or community projects.

https://www.tutor2u.net/economics/reference/key-diagrams-positive-production-externalities#:~:text=Positive%20production%20externalities%20occur%20when,The%20external%20costs%20are%20negative.

Question 16

Negative consumption externalities

Answer 16

Negative externality that arises from consumption of a good or service by consumers.

Example, passive smoking that causes discomfort and respiratory problems to non-smokers.

Question 17

Graph of negative consumption externalities

Answer 17

X-axis: Quantity
Y-axis: Costs and benefits

MEC (start from 0)
S = MPC = MSC
MSB = MPB - MEC (start with D)
D = MPB (start with MSB)

Analysis of graph:
1. MSB is lower than MPB
2. Assuming no production externalities, socially efficient level of output is at Q where MSB 🟰 MSC
3. Due to external costs of consumption, the level of output is at Q1 where MPC 🟰 MPB which is above the socially efficient level
4. Deadweight welfare loss is below S=MPC=MSC, between D=MPB and MSB=MPB-MEC
5. At S=MPC=MSC intersects with D=MPB, consumers are willing to pay a higher price

1. Assume no production externalities, MPC = MSC
2. MPB downwards sloping
3. As there is negative consumption externalities, there is negative external benefit, MSB < MPB
4. Gap between MPB and MSB is negative external benefit
5. Socially optimum output at MSC = MSB
6. There is over consumption
7. Deadweight welfare loss - misallocation of resources

https://www.youtube.com/watch?v=Bz6FIirwhw4

Question 18

Positive consumption externalities

Answer 18

Positive externalities that arise from consumption of a good or service by consumers.

Example, provision of merit goods such as education. Skilled labour will have improved pay and the benefits extend to their families and to future economic prospects.

Question 19

Graph of positive consumption externalities

Answer 19

X-axis: Quantity
Y-axis: Costs and benefits

S = MPC = MSC
MSB = MPB + MEB
D = MPB
MEB

Analysis of graph:
1. MSB is greater than MPB due to the positive externalities
2. Gap between MSB and MPB is MEB
3. Assuming no external benefits of production, the level of output Q1 is below the social optimum of Q
4. There is underconsumption of good
5. Deadweight welfare loss is above S=MPC=MSC, between MSB=MPB+MEB and D=MPB

1. Assume no production externalities, MPC = MSC
2. D = MPB downward sloping
3. With positive externality, MSB > MPB
4. Market equilibrium (only think about private cost and private benefit)
5. MEB is between MSB and MPB
6. Social benefit is at MSB
7. Social cost is at MPB = MPC = MSC
8. Social benefit > Social cost
9. There is under consumption - allocative inefficient, misallocation of resources
10. Socially optimum output at MSC = MSB
11. Deadweight welfare loss between the three lines

https://www.youtube.com/watch?v=0x9y7DwYRfI

Question 20

Problems created by externalities

Answer 20

1. Lead to over or under production which is an inefficient allocation of resources.
   > Example, factories that produce export items, the firms would incur private costs such as labour, rental and raw materials. These private costs form part of social cost.
   > There are further costs incurred along the production process, which is external costs (negative externality) such as pollution, congestion.
2. When deciding what price and quantity to produce, producers only consider private costs and do not take into account external costs into decision making.
   > Meaning price will be lower than if all social costs were recognised.
   > Therefore, negative externality leads to overproduction and market failure.
3. In positive externality, the good or service may be under provided, as there are benefits enjoy by society as a result of the transaction.
   > Market may produce output that is below the quantity that maximises social welfare.

Question 21

Asymmetric information and moral hazard

Answer 21

1. Underconsumption of merit goods and overconsumption of demerit goods is because consumers make choices based on imperfect information.
2. Quality of information available to consumers varies and can lead to misallocation of resources.
3. If a buyer lacks full information, there is a tendency to overestimate the benefits of consumption.
   > The demand curve is above that if the consumer had perfect information, too much is being bought at too high a price.

Question 22

Asymmetric information

Answer 22

Occurs when one party in the market, usually the seller, has some information that the other party, usually the buyer, does not have.

Question 23

Types of asymmetric information

Answer 23

1. Adverse selection
   > hidden characteristics, when only one party knows more about a situation than the other party
   > example, buyers of used cars may end up purchasing more low quality cars in the market, reducing the market for good quality vehicles // unhealthy people could purchase more life insurance than they need while healthy people may not purchase any life insurance
   > can go for a better one but turns out to be bad, everything goes in the opposite direction
2. Moral hazards
   > hidden actions, when one party takes actions that the other party cannot observe but which affect both of them
   > example, the case of a bank loan where the person who has obtained the loan takes a bigger risk in setting up a business // with insurance, a policyholder may attempt to do something that is prohibited by the terms of the policy

Question 24

Cost-benefit analysis

Answer 24

A method to assess the desirability of a project which takes into account of all cost and benefits, including social costs and social benefits.

Developed to ensure the decision making party includes all costs and benefits when making major economic decisions, particularly on costs and benefits that fall upon people or communities that have no direct involvement with the project.

Question 25

Evaluation for Cost-Benefit analysis

Answer 25

1. Takes a long view and a wider view than a financial appraisal due to the large sums involved.
2. Expensive and time-consuming.
3. Aid in decision making.
   > projects that could produce environmental pollution that result in external costs being imposed on the local community
4. Attempts to quantify opportunity cost to society of the various possible outcomes.
5. Use shadow prices on costs and benefits where no market price is available.
   > Shadow price is one that is applied where there is no recognised market price available.
6. Not possible to have the accurate price if the project had not launched.
7. Difficult to implement CBA.
   > need to include which costs and benefits, how to place monetary value on these costs and benefits
8. Does not always reflect the desirable outcome of certain decisions, particularly when public sector investment is involved.
   > example, new highway project, external costs (pollution) tends to be localised, external benefits (time saving) more likely to be widely spread
9. Outcome of CBA is rejected due to political reasons or local pressure.
10. CBA may be limited in its scope and may not include all those likely to be affected by the project.