1.3.2 - Externalities

Question 1

How are private costs represented diagrammatically?

Answer 1

supply curve
- direct cost to producers of supplying extra units

Question 2

How are private benefits represented diagrammatically?

Answer 2

demand curve
- how much utility gained from extra units consumed

Question 3

What are social costs and benefits?

Answer 3

the total societal cost or benefit of the consumption/sale

Question 4

What are external costs and benefits and when do they exist?

Answer 4

external [blank] = the GAP between societal and private outcomes

external costs exist when social costs outweigh private costs (sc>pc)
- so, others are harmed
- can cause a market to produce the ‘wrong’ quantities of goods when ignored, as the market price is too low
o so, output is higher than the socially efficient level

external benefits exist when social benefits outweigh private benefits (sb>pb)
- so, the benefit is shared between the consumer and others

Question 5

What is a merit good?

Answer 5

• a good that has external benefits
  o so, the benefit to society is greater than the benefit felt by the individual
• these goods tend to be UNDER-PROVIDED in a free market
  o people tend to buy too little as they undervalue or overlook the benefit to others and only take into consideration the fact that their own utility is not maximised

Question 6

What is a demerit good?

Answer 6

• a good that has external costs
  o so, the cost to society is greater than the private cost
• these goods tend to be overprovided by the free market
  o consumers ignore the negative externalities and negative impacts on society/others so they overconsume in relation to what is societally efficient

Question 7

Why might merit goods be under-consumed even if they’re cheap or free

Answer 7

• consumers may undervalue or fail to consider long term benefits to themselves and others
• may mistrust the good
• may face non-price barriers to access
  o time (lack of)
  o access
  o misinformation

Question 8

What is the effect of the size of an externality on market failure?

Answer 8

• the greater the externality, the greater the market failure
• thus the more the price mechanism is disrupted
  o so, prices are less accurate and thus less useful for signalling to allocation of resources
  o so, more misallocation

Question 9

What is a marginal value?

Answer 9

the extra measure from producing or consuming ONE MORE unit

Question 10

Define a ‘marginal private benefit’

Answer 10

extra utility to the individual from consuming one more unit

Question 11

Define a ‘marginal social benefit’

Answer 11

extra benefit to society from consuming one more unit (includes spillover benefits)

Question 12

Define a ‘marginal private cost’

Answer 12

extra cost to the producer/individual-decision-maker from producing one more unit

Question 13

Why can marginal private costs change over the course of production?

Answer 13

• at first, marginal costs may fall as producing more can lead to greater efficiency
  o eg. working at 99% capacity rather than 76%
• then, costs may begin to rise again as producers have to invest more in factors of production to expand capacity

Question 14

Define a ‘marginal social cost’

Answer 14

extra cost to society from producing one more unit (includes spillover costs)

Question 15

What does it mean if marginal social cost is greater than marginal private cost for a product?

Answer 15

means that the product creates a negative externality
- essentially imposes additional costs on third parties that the producer does not pay for

Question 16

Why might the socially efficient quantity of a good with external benefits be higher than the market quantity, EVEN IF CONSUMERS ARE RATIONAL?

Answer 16

• standard economic theory states that a consumer is rational when their economic decisions serve to maximise their own private benefit (marginal utility)
• goods with positive externalities like these will not necessarily maximise personal benefit

Question 17

Describe how to draw the graph to illustrate negative production externalities

Answer 17

• P on y-axis, Q on x-axis
• D=MPB=MSB curve and S=MPC curve intersect at the market equilibrium (B (Q1/P1))
• MSC follows S curve (to its left), diverging as progresses
  o crosses D=MPB=MSB at Q2/P2 (socially efficient/optimum equilibrium)
• vertical AB represents the external cost
• orange area = welfare loss
  o due to producing where MSC>MPC (overproducing demerit goods, so market failure)

Question 18

What is a negative production externality?

Answer 18

when the social cost of production outweighs the private cost paid by the firm
- so, some costs fall on third parties
- can mean market outcome is ‘too much’ output, as producers and consumers act on PRIVATE incentives
o so, output is set where marginal private cost is lesser, not the higher marginal social cost

Question 19

Explain (using the diagram) the outcome of supply of demerit goods in a free market

Answer 19

• with no government intervention, firms supply according to MPC
  o so market settles where MPB=MPC (point B)
• at D curve, D=MPB=MSB
• because MSC > MPC, market output at Q1 is higher than the socially efficient quantity
  o SO, the good is overprovided

Question 20

Explain what welfare loss is, and how it is represented on the diagram of negative production externalities

Answer 20

• welfare loss is the economic inefficiency that occurs when resources are allocated inefficiently
  o so results in diminished overall social welfare
• represented by the shaded triangle ABC
• external cost at Q1 represented by vertical AB
  o MSC - MPC at that output level

Question 21

Give another name for the welfare loss

Answer 21

deadweight loss

Question 22

Explain the socially optimal outcome compared with the market outcome (diagrammatic shit)

Answer 22

• society should produce where MSB = MSC
  o social optimum equilibrium (point C)
• compared with market outcome, Q2<Q1>P1
  o because the “true” cost to society is higher than the firm’s private cost</Q1>

Question 23

Explain why the MSC and MPC curves diverge (gap grows larger as output rises)

Answer 23

• external costs often rise with scale
  o eg. congestion, cumulative pollution
  o so, if more individuals do, social cost increases significantly

Question 24

Why might a firm keep producing even if local residents’ health is getting worse?

Answer 24

because firms’ decisions are based on PRIVATE costs and benefits (to the producer)
- so, may ignore external costs
- unless forced to account for them

Question 25

why MSC-MPC gap can widen as output rises

Answer 25

- can increase as output grows because external costs often rise with scale o eg. congestion, cumulative pollution, noise exposure - one individual producing creates a small harm, whereas many individuals each creating a bit of harm at once means that there is a large cumulative social cost whilst private costs remain the same

Question 26

If the demand had a positive externality, what would happen to the location of the social optimum relative to the private equilibrium?

Answer 26

- would depend on which externality was stronger o positive consumption spillovers push optimum up, negative production spillovers push it down

Question 27

Why would marginal external cost rise faster in a crowded city than in a rural area and why?

Answer 27

- more people in a crowded city than in a rural area - so, the negative externality effects more people - so the marginal external cost is greater

Question 28

What is a positive production externality?

Answer 28

- when the social costs of production are less than the private costs of production o thus society BENEFITS from the production process o eg. a firm that converts a derelict construction site into a new factory, whilst clearing pollution around

Question 29

What is a positive consumption externality?

Answer 29

- happens when other people benefit from YOUR consumption o so, MSB > MPB

Question 30

What is a negative consumption externality?

Answer 30

- when other people are harmed by YOUR consumption o so, MSC > MPC o eg. a baby passively smoking because its parent (consumer) is smoking in the house, so the baby dies -> cost to NHS, emotional cost to partner etc.

Question 31

Explain how to diagrammatically represent positive consumption externalities

Answer 31

- assumption = no external costs associated with producing the merit good in question - P on y-axis, Q on x-axis - S curve (S=MPC=MSC) - D curve (D=MPB) - S and D meet at B, the market equilibrium (Q1, P1) - MSB curve (slopes downwards and diverges from D=MPB curve as progresses) - point Q2/P2 = intersection between MSB curve and S=MPC=MSC curve = socially optimum equilibrium - vertical AB represents marginal external BENEFIT at Q1 - orange area (to the left of socially optimum output) = welfare loss o comes about due to underproduction of merit goods

Question 32

Why can the gap between MSB and D=MPB grow?

Answer 32

- when more people take part, spillover benefits can build up o eg. MSB of vaccinations rise as more people get vaccinated because more people are indirectly protected

Question 33

A local council funds a scheme to increase participation in evening painting classes. On a diagram, would MSB or MPB sit above the other and why?

Answer 33

- MSB sits above o because the classes are subsidised, more people can take part (the MPB) o BECAUSE of this, society at large has benefits: people who may have been committing crimes otherwise are occupied, social cohesion of the community increases etc. o so, MSB > the MPB that individuals gain by painting

Question 34

What are the difficulties with externalities and information gaps?

Answer 34

- it is hard to measure the size of an externality o as relies on value judgements o because many social gains are hard to monetise (especially when benefits are long-term or indirect) - externalities often persist BECAUSE of information gaps o so their choices hinge on private benefits and costs rather than those to society at large

Question 35

Why might governments intervene in cases of market failure?

Answer 35

- when markets ignore external costs or external benefits o because prices then fail to reflect the true social impact of the good - aim is to move output/consumption closer to the socially efficient level (MSB = MSC)

Question 36

How can governments intervene in these cases?

Answer 36

- tradeable pollution permits - indirect taxes - subsidies - provision of the good - provision of information - regulation

Question 37

Explain how governments use indirect taxes to intervene where there is market failure

Answer 37

- per-unit tax can be used where there are negative externalities at play (eg. demerit goods) - this reduces the MPB for producers of demerit goods o thus discourages production where there is overproduction of these demerit goods (the market failure in question) - HOWEVER, could argue that this is circumvented by firms via price rises to account for their profit margins o thus the ramification of the demerit good falls on the consumer and the same amount is produced anyway

Question 38

Explain how governments use subsidies to intervene where there is market failure

Answer 38

- used where positive externalities are at play (eg. merit goods) - this incentivises production/consumption of the merit good, as private costs are reduced o so, underproduction of merit goods (the market failure) is limited

Question 39

Explain how governments use tradeable pollution permits to intervene where there is market failure

Answer 39

- pollution is a negative externality - to limit it, government sets an emissions cap and issues pollution production permits which cumulatively equate to that cap - these permits are then distributed to firms - firms can either choose to buy permits from other firms (increasing their allowance of emissions) or sell their own permits (decreasing their allowance) o firms with cheap methods of cutting their emissions generally choose to sell - thus keeps overall emissions below or at the cap o whilst preserving choice element in production strategies for firms o whilst at a lower cost than imposing uniform regulation would have

Question 40

Explain how governments use direct provision of merit goods to intervene where there is market failure

Answer 40

- occurs when MSB of a certain good is VERY high - government provision funded through taxation (eg. NHS) o thus access doesn't directly depend on ability to pay and maximises marginal external benefit

Question 41

Explain how governments use provision of information to intervene where there is market failure

Answer 41

- externalities (some) persist due to information gaps o eg. someone who drinks alcohol fairly regularly but doesn't fully know the health ramifications is more likely to continue drinking - so, the government can supply this information through ad campaigns, clear labelling and so on to plug the gaps - HOWEVER, this will have very limited impacts on demerit goods that are (highly) addictive, such as cigarettes and vapes

Question 42

Explain how governments use regulation to intervene where there is market failure

Answer 42

- laws and regulations imposed to limit the production and/or consumption of demerit goods o eg. banning the production and sale of certain drugs like cocaine o banning advertisement for cigarettes too - can work quickly - does not rely on consumers calculating costs o HOWEVER, may create enforcement costs and bad side effects like black markets