Externalities - A- Level Economics
Externalities
Externalities & Market Failure
Externalities are costs or benefits that are external to a transaction-‐ they are third party effects which are ignored by the price mechanism.
In a free market, producers and consumers are self-‐interested economic agents-‐ they only consider the effect of purchasing a good on themselves. Therefore, the wider effect on people around them is not considered when demand and supply is determined, and hence externalities are ignored by the price mechanism.
This implies that decisions will not be made in the best interests of society-‐ there will be a net welfare loss in society, and hence market failure. Externalities can arise in either consumption or demand.
External, Private and Social Costs
External Costs are costs external to the transaction-‐ they are negative third party effects which are ignored by the price mechanism.
Private Costs are internal costs of a transaction which are incurred by an individual producer or consumer-‐ they are taken into account by the price mechanism.
Social Costs are the total costs of a transaction to society (private costs + social costs).
External, Private and Social Benefits
External Benefits are benefits external to the transaction-‐ they are positive third party effects which are ignored by the price mechanism.
Private Benefits are internal benefits of a transaction which are incurred by an individual producer or consumer-‐ they are taken into account by the price mechanism.
Social Benefits are the total benefits of a transaction to society (private benefits + social benefits).
Examples
| Externality | Example |
|---|---|
| Negative production externality | A factory polluting a river bears a cost to fisherman. |
| Negative consumption externality | Smoking bears a cost to others due to passive smoking. |
| Private Cost | A person smoking has a health cost on the individual |
| Positive production externality | A chemical firm purifying their waste water benefits others |
| Positive consumption externality | Vaccination of an individual reduces others catching the disease from that individual |
| Private Benefit | A consumer buying a car enjoys the private benefits of comfort, enjoyment and convenience. |
Free Market Equilibrium
The free market equilibrium is the point at which marginal private cost equals marginal private benefit.
The supply curve is the marginal private cost curve (MPC)
The demand curve is the marginal private benefit curve (MPB)*
The equilibrium point is where MPC = MPB
* Economists assume that it is possible to measure the benefit obtained from consuming a good by the price people are willing to pay for it.
Social Optimum Equilibrium
The social optimum equilibrium is the point at which marginal social cost equals marginal social benefit. Welfare is maximised at this point.
If production is below the equilibrium, then MSC < MSB, welfare could be increased by raising output.
If production is above the optimum, then the MSC > MSB, welfare could be increased by decreasing output.
N.B. If MSC < MSB, the social benefit of consuming an additional good is greater than the social cost.
Welfare Triangle and External Costs
Example: Production of Toxic Chemicals
We can show the welfare loss to society due to negative externalities.
It is assumed that there are no external benefits, so therefore marginal private benefit equals marginal social benefit.
Therefore we can see that if external costs are ignored, there is under-‐pricing and over-‐ production.
Welfare Triangle and External Benefits
Example: Consumption of Vaccinations
We can show the welfare loss to society due to positive externalities.
It is assumed that there are no external costs, so therefore marginal social cost equals marginal private cost.
Therefore we can see that if external benefits are ignored, there is over‐pricing and under ‐ consumption.
Externalities are the costs or benefits that are not reflected in the market price of a good or service. They are the consequences of production or consumption activities that affect third parties who are not involved in the transaction.
Externalities can be positive or negative. Positive externalities are the benefits that spill over to third parties, such as education or research. Negative externalities are the costs that spill over to third parties, such as pollution or noise.
Externalities affect market outcomes by creating market failures. When externalities are present, the market price does not reflect the true social cost or benefit of the good or service. This leads to overproduction or underproduction of the good or service and inefficient allocation of resources.
The government can use taxes, subsidies, and regulations to address externalities. Taxes and subsidies can internalize the external cost or benefit by making the producer or consumer pay or receive compensation for the externalities. Regulations can impose standards or limits on the level of pollution or noise to reduce the externalities.
The Coase Theorem is a theory that suggests that if property rights are clearly defined and transaction costs are low, then the market participants can negotiate and reach an efficient outcome even in the presence of externalities.
The tragedy of the commons is a situation where multiple users have access to a common resource, such as a fishery or a forest, and each user has an incentive to overuse the resource for their own benefit. This can lead to depletion or degradation of the resource and negative externalities.
Public goods are goods that are non-excludable and non-rivalrous, meaning that one person’s consumption of the good does not reduce the availability for others. Public goods often have positive externalities because their benefits spill over to others who do not pay for them. Therefore, the market may underprovide public goods, and the government may need to intervene to ensure their provision.
Some examples of negative externalities are pollution from factories, noise from airports, and congestion on roads. Some examples of positive externalities are education, vaccination, and research and development.
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