1.3.2 Externalities

PRIVATE COSTS/BENEFITS

PRIVATE COSTS/BENEFITS

• costs/benefits to the individual participating in the economic activity

• The demand curve represents private benefits and the supply curve represents private costs

SOCIAL COSTS/BENEFITS

• costs/benefits of the activity to society as a whole

EXTERNAL COSTS/BENEFITS

• costs/benefits to a third party not involved in the economic activity

• They are the difference between private costs/benefits and social costs/benefits.

MERIT GOOD

• a good with external benefits, where the benefit to society is greater than the benefit to the individual

• These goods tend to be underprovided by the free market

DEMERIT GOOD

• a good with external costs, where the cost to society is greater than the cost to the individual

• They tend to be over-provided by the free market

EXTERNALITIES DIAGRAM

Externalities diagram look at marginal costs/benefits- the extra cost/benefit of producing/consuming one extra unit of the good

• MPB- the extra satisfaction gained by the individual from consuming one more of a good

• MSB- extra gain to society from the consumption of one more good

• MPC- extra cost to the individual from producing one more of the good

• MSC- extra cost to society from the production of one more good.

NEGATIVE PRODUCTION EXTERNALITIES

• occurs when social costs are greater than private costs

• The market will ignore the external costs involved in producing a good (It will produce where MPB=MPC, the market equilibrium, at Q1P1)

• At Q1, the costs to the society are higher than the benefits to society resulting in welfare loss(orange)

• The external cost at Q1 is equal to the line AB

• The economy should produce where MSB=MSC, the social optimum position, at Q2P2

• The difference between marginal social cost and the marginal private cost increases as output grows, because external costs grow the more that people do something (e.g. smoking)

POSITIVE CONSUMPTION EXTERNALITIES

• occurs when social benefits are greater than social

  costs

• diagram- the market left to its own devices will produce where MPB=MPC, it will not consider the benefits to society so will produce Q1P1

• If the market considers all the benefits, it would produce where MSB=MSC at Q2P2

• The failure of the market to consider the external benefits has led to the misallocation of resources and so there is an underproduction of Q1-Q2

• This leads to a welfare loss (orange)

• The line AB represents the external benefit

• the difference between MPB and MSB grows since external benefits grow the more people that undertake the activity (e.g. vaccinations)

GOV INTERVENTION

• indirect taxes and subsidies

• tradable pollution permits

• provision of the good

• provision of info

• regulation

INDIRECT TAXES AND SUBSIDIES

• Taxes can be put on goods with negative externalities

  and subsidies on goods with positive externalities

• These help to internalise the externalities, moving production closer to the social optimum position

TRADABLE POLLUTION PERMITS

• These allow firms to produce up to a certain amount of pollution, and can be traded amongst firms so give them choice whilst reducing the total level of pollution

PROVISION OF THE GOOD

• When social benefits are very high, the government may

  decide to provide the good through taxation

• They do this with healthcare and education

PROVISION OF INFO

• Since some externalities are associated with info gaps, the gov can provide info to help people make informed decisions and acknowledge external costs

REGULATION

• This could limit consumption of goods with negative externalities

• E.G. banning advertising of smoking