4.1.8.4 - Positive and Negative Externalities in Consumption and Production

Externality

A 'spillover' effect from production or consumption that affects third parties either positively or negatively

Positive Externality

A spillover effect from production or consumption that affects third parties positively

Negative Externality

A spillover effect from production or consumption that affects third parties negatively

Production Externality

A positive or negative externality arising from the production of a good or service

- Divergence between private & social costs (MSC & MPC curves)

Consumption Externality

A positive or negative externality arising from the consumptionof a good or service

- Divergence between private & social benefits (MSB & MPB curves)

Social Cost =

Private Cost + External Cost

Social Benefit =

Private Benefit + External Benefit

Positive Production Externality Analysis (9 marker)

- In free market --> producers consider own actions --> so equilibrium is at point A where MPC=MPB

- Positive Production Externality occurs where the production of a good benefits third parties [insert application]

- This means at Point A --> private cost [insert application] is greater social cost (shown by MPC>MSC) --> so an external benefit exists of A-B.

- Socially optimal point is at C where MSC=MSB at Ps, Qs.

- Therefore, the good is underproduced at Qm and overpriced at Pm compared to what is best for society.

- There is under allocation of scarce resources, resulting in Deadweight Welfare Loss shown by area ABC

- Therefore, allocative inefficiency occurs, resulting in partial market failure

Negative Production Externality Analysis (9 marker)

- In free market, producers consider own actions --> so equilibrium is at point A where MPC=MPB

- Negative production externality occurs where the production of a good costs to third parties. [insert application]

- This means that at point A --> social cost [insert application] is greater than private cost (shown by MSC>MPC) --> so an external cost exists of A-B

- Socially optimum point is at C where MSC=MSB at Ps, Qs

- Therefore, the good is overproduced at Qm and underpriced at Pm compared to what is best for society

- There is over allocation of scarce resources, resulting in Deadweight Welfare Loss shown by area ABC

- Therefore, allocative inefficiency occurs, resulting in partial market failure

Positive Consumption Externality

- In free market, producers consider own actions --> so equilibrium at point A where MPB=MPC

- Positive consumption externality occurs where the consumption of a good benefits to third parties. [insert application]

- Therefore at point A, social benefit [insert application] is greater than private benefit (shown by MSB>MPB) --> external benefit exists of A-B

- Socially optimum point at C where MSB=MSC at Ps, Qs

- Therefore, the goods are under consumed at Qm compared to what is best for society

- There is under allocation of scarce resources, resulting in Deadweight Welfare Loss shown by area ABC

- Therefore, allocative inefficiency occurs, resulting in partial market failure

Negative Consumption Externality

- In free market, producers consider own actions --> so equilibrium is at point A where MPC=MPC

- Negative consumption externality occurs where the consumption of a good costs to third parties. [insert application]

- This means that at point A --> private benefit [insert application] is greater than social benefit (shown by MPB>MSB) --> so an external cost exists of A-B

- Socially optimum point is at C where MSC=MSB at Ps, Qs

- Therefore, the goods are over consumed at Qm compared to what is best for society

- There is over allocation of scarce resources, resulting in The Deadweight Welfare Loss shown by area ABC

- Therefore, allocative inefficiency occurs, resulting in partial market failure

Why do the MSB & MPB or MSC & MPC curves not have the same gradient / diverge?

Because the marginal external cost (MEC) is not always constant for each good consumed.

- Additional external cost is increasing for each successive consumption/production

Property Rights

The authority to determine how an economic resource is used - who gets it, who is excluded from it, what it's used for etc.

Property Rights leading to the Tragedy of the Commons

Non-excludable resources tend not to be looked after, or are overused, because the lack of clear property rights means it's not worth any one person taking responbility for them.

Moral Hazard

Risk that people will behave antisocially/recklessly when they won't bear the costs of their own behaviour

Why can property rights lead to externalities, hence market failure

- The LACK of property rights means no one owns the good so no one is responsible and can be held accountable for their actions.

- As people will act in their self-interest (+ moral hazard), people have no incentive to look after the good

- Leads to negative externalities therefore market failure