1.3.2 Externalities

Question 1

What is an externality?

Answer 1

An externality is the cost or benefit a third party receives from an economictransaction outside of the market mechanism. In other words, it is the spillover effect of the production or consumption of a good or service.
Externalities can be positive (external benefits) or negative (external costs).

Question 2

Why may it be hard to determine the monetary value of an externality?

Answer 2

Market fails involves a value judgement. For example, it is
hard to decide what the cost of pollution to society is. Different individualswill put a different value on it, depending on their own experiences with pollution, such as how polluted their home town is. This makes determininggovernment policies difficult, too.

Question 3

What are private costs?

Answer 3

• Private costs are the costs to economic agents involved directly in an economictransaction.
• Producers are concerned with private costs of production. For example, the rent, the cost of machinery and labour, insurance, transport and paying for raw materials are private costs.
• This determines how much the producer will supply.
• It could refer to the market price which the consumer pays for the good.

Question 4

What are social costs?

Answer 4

This is calculated by private costs plus external costs.
It is the cost to society as a whole.

Question 5

What are external costs?

Answer 5

The costs/benefits to a third party not involved in the economic activity. They are the difference between private costs/benefits and social costs/benefits.

Question 6

How do you show external costs on a digram?

Answer 6

Shown by the vertical distance between the two
curves. In other words, external costs are the difference between private costs and social costs.
It can be seen that marginal social costs (MSC) and marginal private costs (MPC) diverge from each other. External costs increase disproportionately with increased
output.

Question 7

What is a merit good?

Answer 7

A good with external benefits, where the benefit to society is greater than the benefit to the individual. These goods tend to be underprovided by the free market.

Question 8

What is a demerit good?

Answer 8

In economics, demerit goods are products or services that are over-consumed or consumed to a greater extent than is considered socially desirable from the perspective of society as a whole. They have negative externalities.

Question 9

Define marginal cost/benefit.

Answer 9

The extra cost/benefit of producing/consuming one extra unit of the good.
(For example, the marginal private benefit (MPB) is the extra satisfaction gained by the individual from consuming one more of a good and the marginal social benefit (MSB) is the extra gain to society from the consumption of one more good)

Question 10

What is the marginal private cost?

Answer 10

The extra cost to the individual from producing one more of the good and the marginal social cost (MSC) is the
extra cost to society from the production of one more good

Question 11

What is private benefit

Answer 11

Consumers are concerned with the private benefit derived from the consumption of a good. The price the consumer is prepared to pay determines this.
Private benefits could also be a firm’s revenue from selling a good.

Question 12

What is social benefit?

Answer 12

Social benefits are private benefits plus external benefits.
On a diagram, external benefits are the difference between private and social benefits.
Similarly to external costs, external benefits increase disproportionately as output increases.

Question 13

What is the Social optimum position?

Answer 13

This is where MSC = MSB and it is the point of maximum welfare.
The social costs made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output.

Question 14

Draw a negative production externalities digram.

Answer 14

Weafare loss should connect the two equlibrum and point to the social equilibrium.

Question 15

Negative externalities of production occur when ……

Answer 15

social costs are greater than private costs.

Question 16

Where will the market choie to produce?

Answer 16

The market left to operate freely will ignore the external costs involved in producing a good. It will produce where MPB=MPC, the market equilibrium, at Q1P1.

Question 17

What is a welfare loss?

Answer 17

The costs to the society are higher than the benefits to society resulting in the loss of welfare equal to the shaded area

Question 18

Where would the external costs be on this digram?

Answer 18

The external cost at Q1 is equal to the line AB.

Question 19

Where should the economy produce on this digram?

Answer 19

The economy should produce
where MSB=MSC, the social optimum position, at Q2P2

Question 20

Why does the difference between marginal social cost and the marginal private cost increases as output grows?

Answer 20

Because external costs grow the more that people do something. If one person drove their car, then the external costs of pollution would be very small. The more people that drive cars, the larger the external cost of pollution. The noise pollution from airplanes and industrial waste are twoexamples of negative production externalities.

Question 21

Draw a positive consumption externalities digram.

Answer 21

Question 22

Positive externalities of consumption occur when…..

Answer 22

social benefits are greater than social costs.

Question 23

Where on the digram will the market choice to produce?

Answer 23

In the diagram, the market left to its own devices will produce where MPB=MPC, it will
not consider the benefits to society so will produce Q1P1.

Question 24

Where is the social equilibrium, where the market should produce?

Answer 24

If the market considers all the benefits, it would produce where MSB=MSC at Q2P2.

Question 25

Where has an underproduction occurred, what does this lead to?

Answer 25

The failure of the market to consider the external benefits has led to the misallocation of resources and so there is an underproduction of Q1-Q2. This leads to a welfare loss of the shaded area

Question 26

What represents the external benefit?

Answer 26

The line AB represents the external benefit

Question 27

Why does the difference between marginal private benefit and marginal social benefit grow?

Answer 27

External benefits grow the more people that undertake the activity, for example the external benefits of vaccinations are larger the more people that have the vaccination. Healthcare and education are two examples of positive consumptionexternalities.

Question 28

List the ways that a government may interven to fix external costs/benefits.

Answer 28

1. Indirect taxes and subsidies 2. Tradable pollution permits 3. Provision of the good 4. Provision of information 5. Regulation

Question 29

How does Indirect taxes and subsidies make sure that the market considers external costs and benefits?

Answer 29

Taxes can be put on goods with negative externalities and subsidies on goods with positive externalities. These help to internalise the externalities, moving production closer to the social optimum position.

Question 30

How do tradeable pollution permits and subsidies make sure that the market considers external costs and benefits?

Answer 30

These allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them choice whilst reducing the total level of pollution.

Question 31

How does Provide the good and subsidies make sure that the market considers external costs and benefits?

Answer 31

When social benefits are very high, the government may decide to provide the good through taxation. They do this with healthcare and education.

Question 32

How does Provision of information and subsidies make sure that the market considers external costs and benefits?

Answer 32

Since some externalities are associated with information gaps, the government can provide information to help people make informed decisions and acknowledge external costs.

Question 33

How does regulation idies make sure that the market considers external costs and benefits?

Answer 33

This could limit consumption of goods with negative externalities, for example banning advertising of smoking etc.