6. Positive externalities

Positive externalities

When the production or consumption of a good or service benefits an uninvolved third party

Positive production externalities

When the production of a good or service benefits an uninvolved third party

Graphical representation

MPC > MSC

At Qm, MSB > MPB: underallocation of resources

Types of government intervention

1. Direct provision of research and development

2. Subsidies (shift MPC downwards to meet MSC)

Positive consumption externalities

When the consumption of a good or service benefits an uninvolved third party

Graphical representation

MPB < MSB

At Qm, MSB > MSC —> underallocation of resources

Merit goods

Products which benefit their consumers but are generally underprovided and underconsumed in a free market due to the following reasons:

• They often have positive externalities (but consumers only want to pay for the private benefits)

• Some consumers cannot afford to pay

• Asymmetric information: some consumers are not fully aware of the benefits of the product

• Ignorance: some consumers choose to ignore the benefits of the product

Government intervention for positive consumption externalities (4)

• Legislation/regulation

  • Some products are mandated (e.g. COVID vaccines)

  • The gov. may apply conditions to the consumption of other goods and services (e.g. unvaccinated children could not go to childcare)

• Advertising and campaigning

  • Ads and government campaigns

• Direct provision (e.g. public schools, public hospitals)

• Subsidies: increases quantity produced and affordability

Graph of regulation/legislation AND advertising

Graph of direct provision

Graph for government subsidy

Pros and cons of direct provision & subsidy

Pros

• Changes incentives of producers and consumers

• (Direct provision): guaranteed outcome

• Increase affordability

Cons

• High government spending, involving opportunity costs

• Can benefit people who don’t need it

• Influenced by politics

• (Direct provision) the government may lack expertise and resources

• (Subsidy) encourages insufficiencies in firms

• Technical difficulties

Pros and cons of legislation/regulation

Pros

• Guaranteed outcome (firms and consumers are compelled to follow the rules)

• Can target specific products

Cons

• Ethical issues

• Enforcement costs

• Parallel markets may form

• Results in higher equilibrium price

Pros and cons of advertising and education campaigns

Pros

• Reduces asymmetric information, solving underconsumption

• Lower cost than direct provision and subsidies

Cons

• Difficult to predict impact

• High government spending

• Causes a higher equilibrium price

Define public goods

Socially desirable products which are consumed by everyone and from which no one can be excluded from. They have 2 characteristics:

• Non-rivalrous: consumption by one person does not cause a reduction in availability for others

• Non-excludable: impossible to prevent anyone from consuming it, even if they haven’t paid

These characteristics often mean that they are underprovided by private firms

E.g. lighthouse, police force, non-toll roads, national defence

Why are public goods a type of market failure?

1. Non-excludability: Consumers who do not pay for public goods can still consume them

2. Free-rider problem: Many consumers use public goods but don’t pay

3. Private firms which produced the public goods are unable to cover costs/make sufficient profit

4. Underallocation of resources to public goods

5. Government needs to intervene

Government intervention for public goods

The government may need to use tax revenues to directly provide public goods and make them free to use for the public.

Technical difficulties

• Which public goods to provide

• How much to provide

• Opportunity cost

The government may need to use cost-benefit analysis to see which products would provide the greatest social benefits for a given amount of money

BUT because there is no market price for public goods, the government may need to estimate the value to society or conduct surveys (but consumers are likely to exaggerate the value of public goods)

Define contracting out

When the government makes an agreement with an external, private firm to carry out an activity that it was previously doing itself. (Note: the production is still financed by tax revenue)

Advantages of contracting out (5)

1. Competitive tendering: when multiple private firms compete for the same contract, the firm offering the lowest price is selected, minimising government spending

2. Private firms often have access to more advanced technology and specialised knowledge

3. Private firms are often more innovative and flexible

4. The government can monitor progress and quality

5. Expenses may be lower and quality might be better than if the government did not contract out

Disadvantages of contracting out (6)

1. The government becomes less accountable

2. Risk of poor contracts: high price and low quality

3. Quality may be low if the government prioritises price over quantity

4. The government loses control over the service to a certain extent

5. Monitoring can be costly

6. Influenced by politics (e.g. which private firms are hired)