Topic 5.4 Positive and negative externalities + 5.5 Merit and Demerit Goods Flashcards
Externality definition
An externality is the cost/benefit a third party recieves from an economic transaction outside the market mechanism.
4 Types of Externalitites
Positive Consumption Externalities
Positive Production Externalities
Negative Consumption Externalities
Negative Production Externalities
Negative Production Externalities
These are the costs to 3rd parties as a result of the actions by producers.
Examples of NPE
Air Pollution, Deforestation, Resource Depletion.
Negative Production Externality Diagram
- One Demand Curve labelled MSB = MPB = D
- 2 Supply curves, one called MPC and the other shifted to it’s left is called MSC.
- Welfare Loss, the triangle created by further extending the Q1 line (always points to allocative efficiency).
Social Cost Formula (NPE)
Social Cost = Private Cost + External Cost
(Social Cost > Private Cost)
Where does the market operate at (NPE, PPE/NCE,PCE)
The market will allocate resources at the private optimum (NPE/PPE: where MPC = MPB/MSB/D|NCE/PCE where MPB = MSC/MPC/S)
Where is allocative efficiency (NPE, PPE/NCE,PCE)
The social optimum (NPE/PPE: where MSC = MPB/MSB/D|NCE/PCE where MSB = MSC/MPC/S)
Analysis with NPE
- Firms ignoring social costs due to self interest (they only consider their private cost resulting in the market operating at the private optimum)
- Furthermore the price is too low (P1) as it only accounts for the private costs, not external costs.
- This results in overproduction (Q1 - Q2)
- Thus there is a misallocation of resources culminating the welfare loss
Negative Consumption Externalies
Costs to 3rd parties as a result of the actions of consumers.
Examples of NCE
Smoking, excessive alcohol, gambling, excessive junk food
Social Benefit Formula (NCE)
SB = PB + EB (the External Benefit is negative)
SB < PB
Negative Consumption Externality Diagram
- One Supply Curve labelled MSC = MPC = S
- 2 Demand curves, one called MPB and the other shifted to its left is called MSB.
- Welfare Loss is the triangle created by extending the Q1 line (always points to allocative efficiency).
Analysis with NCE
Consumers are ignoring the full social benefit of their actions and pursuing their private benefit due to self-interest. This results in the market allocating resources at Q1P1 (where MPC = MPB), which leads to an over-consumption/production of the externality therefore, there is a misallocation of resources (where too many resources are being allocated to that market) then socially desireable thus allocative inefficiency and a welfare loss to society.
Positive Consumption Externalities
Benefits to 3rd parties as a result of the actions of consumers.
Examples of PCE
Healthcare (e.g vaccination), Education (more productive), Exercise/Healthy eating (less strain on the NHS/more often work).
Social Benefit Formula (PCE)
Social Benefit = Private Benefit + External Benefit
(External Benefit is positive)
Positive Consumption Externality Diagram
- One Supply Curve labelled MSC = MPC = S
- 2 Demand curves, one called MPB and the other shifted to its right is called MSB.
- Welfare Loss is the triangle created by extending the Q1 line (always points to allocative efficiency).
Analysis with PCE
Individual consumers are ignoring the full social benefit of their actions due to self-interest - ignoring the external benefits. As a result, the market allocates scarce resources to the private optimum, which means that social benefit > social cost so we are missing out on extra benefit (creating the welfare loss). This means there is an underconsumption and underproduction of PCE goods which results in a misallocation of resources.
Positive Production Externalities
Benefits to 3rd parties as a result of the actions of producers.
Examples of PPE
In-work training, R&D
Social Cost Formula (PPE)
Social Cost = Private Cost + External Costs
(External costs negative)
Positive Production Externality Diagram
- One Demand Curve labelled MSB = MPB = D
- 2 Supply curves, one called MPC and the other shifted to its right is called MSC.
- Welfare Loss is the triangle created by extending the Q1 line (always points to allocative efficiency).
Analysis of PPE
Firms only consider their private costs and don’t consider their social costs (as they ignore EC) due to self-interest. This means that the market allocates resources at the private optimum P1Q1, which results in an underproduction and underconsumption taking place, therefore allocative inefficiency and partial market failure.
Merit Goods
These cause positive consumption externalities
E.g Education, Healthcare.
Demerit Goods
These cause negative consumption externalities
E.g Cigarettes, Alcohol.
