positive and negative externalities & merit and demerit goods

explain what externalities are

• public goods or public ‘bads’ that are dumped on third parties outside the market

• they are ignored by the price mechanism

• no market in which they can be bought and sold in thus an example of a missing market

• an example of market failure as they lead to either under production or over consumption of certain goods and services

positive externalities

• external benefits that occur when the consumption or production of the good causes a benefit to a third party where the social benefit is greater than the private benefit

negative externalities

• external costs that occur when the consumption of production of a good causes costs to a third party, where social cost is greater than the private cost

explain what property rights are

• exclusive authority to determine how a resource is used

• most goods in the economy are private goods which owners can exercise private property rights over, preventing others from consuming the good or its benefits

• property rights cannot be exercised with pure public goods due to their defining characteristics of non-excludability resulting in the free-rider problem

• this is not always the case with quasi-public goods as they might be excludable

• for markets to operate efficiently property rights must be clearly defined and protected

  • this may be through government legislation and regulation

production externalities

• an externality (positive or negative) generated in the course of producing a good or service

explain with the use of a diagram the concept negative production externalities

• when the marginal social cost of producing a good exceeds the marginal private cost

• due to negative externalities such as pollution being discharged during production the MSC of production process exceed the MPC

  • as shown by the MSC curve being above the MPC curve

• firm maximises private benefit by producing at output q1 where MPB=MPC which is the free market equilibrium and the market fails

• this is because the social optimum level of output is q2 where MSC=MSB

• the privately optimal level of output is greater than the socially optimal level of production leading to the market overproducing by q1-q2 due to the wrong incentive being created

• the wrong quantity produced and the price is too cheap which is a type of partial market failure

• the shaded area abc shows welfare loss which occurs when the free-market output of q1 is used

explain with the use of a diagram the concept positive production externalities

• when the marginal private cost of producing a good exceeds the marginal social cost

• the market price only reflects the private cost of consuming the product even though the social benefits are higher because of the existence of positive externalities

• this is an example of a missing market as firms cannot charge for the external benefits people receive

  • warm clean water discharged by power stations

• firm maximises private benefit at q1 which is the free market equilibrium thus the market fails

• this is because the private optimum price is greater than the socially optimum price leading to the market underproducing by q1-q2 due to the wrong incentive being created

• the price is too high leading to less being produced however if the price was lower, more of the good would be consumed by society

consumption externalities

• an externality generated through the course of consuming a good

negative externalities in consumption (draw the diagram)

• the marginal private benefit exceeds the marginal social benefits leading to negative effects being experienced by third parties when someone consumes the good

• demerit good

positive externalities in consumption (draw the diagram)

• the marginal social benefits exceeds the marginal private benefits leading to external benefits (utility) being experienced by a third party which comes from someone else’s consumption decision

• merit goods

explain what merit goods are

• a good for which the social benefits of consumption exceed the private benefits

• the long term private benefits of consumption exceed the short term benefits of consumption

  • when paying into a pension scheme, no utility is derived in the short term as you pay into it for decades but once you retire, the economic welfare obtained is large

• can lead to partial market failure if the wrong quantity is delivered to the market

explain what the two important characteristics of merit goods are

• positive externalities

  • consumption of a merit good results in positive externalities which benefit other people

  • social benefit to the wider society is therefore greater than the private benefit to the purchaser of the merit good such as education or healthcare

• information failure

  • the long term benefits of consuming a merit good exceed the short term benefits of consumption yet when people decide how much to consume of a good people consider the short term costs and benefits leading to the long term private costs and benefits being undervalued

  • this means that the free market provision of merit goods leads to under provision which is an example of partial market failure

  • therefore there is an argument for the government to provide these products through general taxation or subsidise market provision

  • although this depends on value judgements as not all merit goods will be subsidised

explain what demerit goods are

• a good for which the private benefits of consumption exceeds the social benefits of consumption

• the long-term benefits of consumption are less than the short-term benefits of consumption

explain what the two important characteristics of demerit goods are

• negative externalities

  • consumption of a demerit good generates negative externalities which harm others i.e. inhaling second hand smoke

  • thus the MSB is less than MPB

• information failure

  • young people may downplay the long term private costs of smoking or heavy drinking which they may experience later in life

  • thus the free market provision of demerit goods lead to overproduction which is an example of a market failure

with the help of a diagram explain how the over production of demerit goods can be fixed with government intervention

• when tobacco supplied by the free market, too much is consumed when unadjusted by taxes or a minimum price law

• the privately optimal level of consumption is q1 where MPB=MPC

• this is greater than the socially optimum level of consumption q2 located where MSB=MSC

• therefore free market provision of demerit goods leads to overproduction by q1-q2

• to bring about the socially optimum level of consumption at q2, an indirect tax equal to the distance between points B and D which is the marginal external costs could be imposed which increases the price to p2 and reduces quantity to q2 where MSB=MSC

with the help of a diagram explain how the under production of merit goods can be fixed with government intervention

• when education is only provided by the free market at the market price of p1 unadjusted by subsidy, too little of the merit good is consumed

• many people especially the poor would be uneducated

• the privately optimum level of consumption is q1 determined at point A where MPC=MPB

• this is below the socially optimum level of consumption at q2 determined at point B where MSC=MSB

• thus free market provision leads to under consumption

• welfare loss is shown by area ABC

• government reacts by reducing the price of education to p2 and consumption rises to socially optimum level q2

explain how value judgement plays a role in merit and demerit goods

• there are some goods which are accepted by most people as being clear-cut examples of being merit and demerit goods such as healthcare and smoking respectively

• there are some goods and services, due to personal values, ethics and religion that are less clear such as contraception, sterilisation and abortions