the concepts of positive and negative externalities of production and consumption with a diagrammatic representation of the welfare loss/benefit associated with them

Question 1

What is an externality

Answer 1

• a cost/benefit suffered/gained by a third party as a result of an economic transaction
• when production/consumption impose external costs/benefits on 3rd parties for which no appropriate compensation is paid or accrued

Question 2

Negative Externality

Answer 2

• costs paid by third parties arising from the production/consumption of a g/s
• these costs are not paid by producers who have created the damage –> costs will be zero for the firm –> inflates profit
• leads to misallocation of resources as socially undesirable g/s will be over-produced –> lowers society’s general wellbeing and living standards
• factories producing chemicals which realise unpleasant odours that we are forced to breathe even though we do not consume their products

Question 3

Positive Externality

Answer 3

• benefits gained by a third party arising from the production/consumption of a g/s
• result in the misallocation of resources and underproduction of socially beneficial g/s –> decision makers do not factor in the full value of all the benefits gained from a given economic activity
• market failure –> misallocation of resources in sufficient quantities –> general wellbeing lower
• provision of education –> brings wider social benefits for society –> increasing general welbeing

Question 4

Private and Social Costs

Answer 4

SC = PC + EC

SB = PB + EB