8.4 - Positive and negative externalities in consumption and production

Define an externality?

A public good, in the case of an external benefit, or a public bad, in the case of an external cost, that is dumped on third parties outside the market.

What is a positive externality?

An external benefit that occurs when the consumption or production of a good causes a benefit to a third party, where the social cost is greater than the private benefit.

What is a negative externality?

An external cost that occurs when the consumption or production of a good causes costs to a third party, where the social cost is greater than the private benefit.

What is the free rider problem?

A free rider is someone who benefits without paying as a result of non excludability. Customers may choose not to pay for a good, preferring instead to free ride, with the result that the incentive to provide the good through the market disappears

Why does the free rider problem occur?

Occurs when non excludability leads to a situation in which not enough customers choose to pay for a good, preferring instead to free ride, with the result that the incentive to provide the good through the market disappears and a missing market may result.

What is a production externality?

An externality generated in the course of producing a good or service

What is an example of a negative production externality?

Pollution that a power station evades by dumping it on others such as people living in surrounding homes

What is an example of a positive production externality?

The production of electricity from the power plant

What is a consumption externality?

An externality generated in the course of consuming a good or service

What is an example of a negative consumption externality?

The noise of people eating popcorn whilst watching a movie

What is an example of a positive consumption externality?

Pleasure gained by a passer by walking past beautiful buildings

How do negative externalities mean the wrong quantity of a good is produced and consumed?

If negative externalities are generated, goods end up being too cheap or underpriced. The market has created the wrong incentives. Because prices under reflect the true costs of production, which include the cost of the negative externalities, too much of a good ends up being produced and consumed.

How do positive externalities mean the wrong quantity of a good is produced and consumed?

Prices end up being too high, leading to the wrong quantity of the good to be produced and consumed. Once again, the market has created the wrong incentives, which discourages consumption. In this case, prices over reflect the true costs of production. Noe enough of the good ends up being produced or consumed.

When does private benefit maximisation occur?

marginal private benefit (MPB) = marginal private cost (MPC)

When does the social optimum occur?

marginal social benefit (MSB) = marginal social cost (MSC)

What is the social benefit?

Defined as private benefit plus external benefit

What is social cost?

Defined as private cost plus external cost

How does negative production externalities cause market failure shown on a diagram?

(pg 243)

The marginal private benefit accruing to the power station from the production of electricity and the social benefit received by the community are the same and are shown the by the downward sloping curve. Because pollution is discharged in the course of production, the marginal social cost exceeds the marginal private cost so the MSC is above the MPC curve. The vertical distance between the two curves shows the marginal external cost (MEC).

The power station maximisises private benefit at output Q1. However the socially optimal level is Q2. The privately optimal level is thus greater than the socially optimal level of production, so the market forces over produce electricity by the amount Q1-Q2. The market fails because the power station produces the wrong quantity of the good. At the price P1, electricity is too cheap and would have to be at P2 to bring about the socially optimal level of consumption.

The shaded area illustrates the loss of welfare or deadweight loss that exists at the free market output Q1 all the way back to the socially optimal level Q2. this is because for units Q2 to Q1, the social cost of producing each unit of electricity is greater than the benefit society derives from each unit produced - that is, MSC > MSB. Society would be better off is these units, Q2 to Q1 were not produced and the resources were transferred to the production of other products. When production takes place at the socially optimal output, the deadweight loss is eliminated.

How does positive production externalities cause market failure using a diagram?

(pg 244)

Positive production externalities such as these mean that the MSC curve is positioned below the MPC curve. The vertical distance between the two curves shows a negative marginal external cost (MEC) at each level of tree planting.

The shaded area shows the deadweight loss, which exists at the free market output, Q1 at point X, all the way to the socially optimal level of output Q2. When production takes places at the socially optimal level, the DWL is eliminated. This is sometimes referred to as welfare gain. There is a net gain in social welfare if the trees between Q1 and Q2 are planted MSB is greater than the MSC for each of these trees up to the point at which MSB = MSC.

In order to maximise its private benefit, the commercial forestry plants Q1 trees. Q1 is immediately below point X, where MPC = MPB. However, Q1 is less than the socially optimal level of output Q2, located below point Y, where MSC = MSB. The diagram illustrates the fact that, when positive production externalities are generated, the market fails because too little of the good is produced and consumed. Under production and under consumption are depicted by the distance Q2 - Q1.