Externalities

Question 1

Externality

Definition

Answer 1

• An external effect or externality is one which affects an outsider who is not involved in either buying or selling the good or service. Externalities are often referred to as third party or spillover effects
• Externalities can be either positive or negative and can occur at the point of production or the point of consumption

Question 2

Partial market failure

Answer 2

• A functioning market where there is too many or too few resources being used
• There is overproduction/consumption or underproduction/consumption

Question 3

Complete market failure

Answer 3

No public goods produced at all

Question 4

Effects of a trade

Answer 4

• If a trade takes place between a buyer and a seller in such a way that only these two “parties” are affected we say that all the costs and benefits are private and internal
• Trade only takes place if there is a mutual benefit to both parties. This trade will be allocatively efficient since it makes both parties better off and therefore increases social welfare.

Question 5

Private benefits to the buyer

Answer 5

Utility

Question 6

Private costs to the buyer

Answer 6

The price/money paid

Question 7

Private benefits to the seller

Answer 7

Revenue

Question 8

Private costs to the seller

Answer 8

Costs of production

Question 9

Rational person buying

Answer 9

• A rational buyer of a good will go through with the purchase if he believes that there will be a net benefit to him
• Marginal private benefit - extra utility > price

Question 10

Rational person selling

Answer 10

• A rational seller of a good will go through with the sale if she believes that there will be net benefits to her
• Revenue > costs of production

Question 11

Externality equations

4 equations

Answer 11

• Social costs = private costs + external costs
• External costs = social costs - private costs
• Social benefits = private benefits + external benefits
• External benefits = social benefits - private benefits

Question 12

MPC

Answer 12

• Marginal private cost
• The cost to a firm of making the next unit of output is the MARGINAL PRIVATE COST
• Only for externalities this is what we call the supply curve

Question 13

MPB

Answer 13

• Marginal private benefits
• The rational buyer will be assessing the extra benefits (or marginal utility) that he/she will personally receive from consuming the good. In this sense the demand curve is a MARGINAL PRIVATE BENEFIT curve
• This is what we call the demand curve only for externalities

Question 14

Free market equilibrium

On a diagram

Answer 14

• Free market welfare is maximised by producing at the point where MPB = MPC
• All units of output add more to total benefit than they do to total cost, because the MPB curve lies above the MPC curve. Each unit of output up to q* results in a NET WELFARE GAIN because it is adding more to consumer benefit than it is adding to the firm’s cost

Question 15

Society

Renewed definition

Answer 15

Society is consumers, producers and all other third parties who are affected by the actions of the consumer and producer