Chap 3: (Positive) Externalities

Definition to use before talking about positive consumption externalities

Positive consumption externalities occur when the consumption of a good positively affects the well-being of third parties.

Explain the divergence between private and social costs for the diagram for positive consumption externalities.

The third parties do not compensate consumers for the external benefits that they enjoy. Hence, such external benefits are unpriced by the market and not reflected in the MPB which only reflects the private benefits of consumption. This causes a divergence between private and social costs, with MSB lying above MPB as MSB = MPB + MEB.

What happens when positive consumption externalities take place without any intervention? (make reference to diagram, eg vaccines)

If left to the free market, equilibrium price is Pm and output Qm. Hence, there is an underconsumption of Qs-Qm units of vaccines and an underallocation of resources to the vaccine market.

What is the impact of positive consumption externalities on society's welfare? (make reference to diagram)

The underconsumption of Qs-Qm results in a loss of welfare for society. This is because MSB exceeds MSC for every unit between Qm and Qs that is underconsumed, ie society would have gained more benefits compared to costs incurred if it had consumed each of these units, and would have been better off if it had consumed the units between Qm and Qs.

The total loss of welfare due to the underconsumption of Qs-Qm is known as deadweight welfare loss, and is represented by area ABC.

What are the two types of solutions for positive consumption externalities?

Subsidies to producers and direct provision by government

What type of approach is subsidies to producers in eliminating positive consumption externalities?

Market based approach

Explain how subsidies to producers can be used to eliminate positive consumption externalities. (eg vaccines)

The government can give a subsidy to producers corresponding to the external marginal benefit i.e. subsidy = MEB at Qs on each unit of vaccine. This shifts the MPC downwards so that the new MPC, which equals MPC-subsidy, coincides with the MPB at Qs

What will happen if subsidies to producers are used to eliminate positive consumption externalities?

The new market equilibrium quantity where MPB = MPC-subsidy now coincides with the socially efficient quantity Qs, where MSB=MSC. If the subsidy accurately reflects the external marginal benefit, the price consumers are paying will drop, and hence the externality would have been internalised.

When the positive externality is so large such that MSB intersects MSC at a price that is zero, what should the government (optimally) do?

Give a full subsidy to bring consumption or production to the socially optimal level of Qs. This is equivalent to free provision of the good.

What are the limitations of using subsidies to producers to solve positive consumption externalities?

Lack of information (government may fail to measure external benefits accurately and thus end up over-subsidising or under-subsidising), opp cost due to budget constraints (government uses its budget to fund many types of expenditures such as education and healthcare)

What are the unintended consequences of using subsidies to producers to solve positive consumption externalities?

May breed inefficiency as it reduces the incentive for providers to stay efficient by finding the lowest cost of production, and place a strain on the government's budget -- subsidies are funded out of tax revenue, may lead to the imposition of higher taxes to meet funding requirements, which has negative economic and political consequences

Explain how direct provision by government can be used to eliminate positive consumption externalities

The government could directly provide goods and services with positive externalities to supplement the provision by the free market. Eg public schools, hospitals. However, the government may still charge nominal fees to the public, hence direct provision by government is not the same as free provision. The government will decide if goods and services will be provided free or at a subsidised rate.

What are the limitations and unintended consequences of direct provision by government being used to eliminate positive consumption externalities? (eg govt hospitals)

It may lead to inefficiency and poor standards of service, as goods and services are not subject to the discipline of the market. Government hospitals are not running on the basis of maximising profits, and there is a lack of incentive to minimise costs and offer the best standard of service as they are not subject to competition. The expenses incurred in running government healthcare services are funded mainly from tax revenue, hence it puts a strain on the government's budget