Externalities

What is an externality in economics?

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism, often referred to as a spillover effect.

What are the two types of externalities?

Positive externalities (external benefits) and negative externalities (external costs).

What types of goods are associated with negative externalities?

Demerit goods, which are usually overprovided due to information failure about their long-run implications.

Give examples of demerit goods and their negative externalities.

Cigarettes and alcohol. A negative externality of cigarettes is second-hand smoke or passive smoking.

What types of goods are associated with positive externalities?

Merit goods, which are usually underprovided due to information failure about their long-run benefits.

Give examples of merit goods and their positive externalities.

Education and healthcare. A positive externality of education is a higher skilled workforce.

Why is it difficult to determine the monetary value of an externality?

The extent of market failure involves a value judgement, as different individuals may place different values on externalities based on their personal experiences.

How does the difficulty in valuing externalities impact government policy?

It complicates the creation of government policies, as it is challenging to agree on the societal cost or benefit of externalities like pollution.

What are private costs in production?

Private costs are the expenses borne by producers, such as rent, machinery, labour, insurance, transport, and raw materials, which determine the supply of goods.

Define marginal private cost (MPC).

Marginal private cost is the cost to a firm of producing one additional unit of a good.

What are social costs?

Social costs are the sum of private costs and external costs associated with production or consumption.

How are marginal social costs (MSC) calculated?

MSC = Marginal External Cost + Marginal Private Cost.

What are private benefits?

Private benefits are the gains consumers or producers derive from consuming or selling a good, such as the price consumers are willing to pay or a firm's revenue.

Define social benefits.

Social benefits are the sum of private benefits and external benefits from the production or consumption of a good.

How is marginal social benefit (MSB) calculated?

MSB = Marginal External Benefit + Marginal Private Benefit.

What are external costs of production?

External costs are negative effects of production or consumption on third parties, like pollution, which are not reflected in market prices.

How do external costs affect market equilibrium?

They cause over-provision and under-pricing, leading to excess social costs over benefits at free market equilibrium.

What is the impact of quantifiable external costs?

They can be considered economic costs, such as the economic cost of road congestion, but others like noise pollution are harder to quantify.

Give an example of an external benefit from production or consumption.

Vaccination programmes reduce diseases and improve public health, which are external benefits not accounted for in the free market.

What is the result of under-provision of goods with external benefits in the free market?

Market failure occurs because marginal social benefits (MSB) exceed marginal private benefits (MPB).

What are environmental externalities?

Environmental externalities are negative impacts from energy consumption, such as pollution, landscape damage, and noise, not reflected in energy prices.