Externalities 1.3.2

What are externalities?

Refer to the unintended side effects or consequences of an economic activity or transaction that affect third parties who are not directly involved in that activity or transaction.

how does inter-connectedness of economic agents cause externalities?

In modern economy, individuals, firms and government engage in economic activities. These interactions often have ripple effects that extend beyond the immediate parties involved. For example when a factory produces goods, it may emit pollutants into the environment, affecting neighbouring communities.

How does public goods cause externalities?

Public goods such as clean air often cause positive externalities because they benefit everyone, whether they contribute to their provision. Individuals may in underinvest in such goods, assuming others will bear the costs.

What are two examples of negative production externalities?

Factory pollution emissions or waste from manufacturing processes

What are two examples of negative consumption externalities?

Household waste and noise & air pollution

What are two examples of positive production externalities?

Reforestation projects and the free-sharing of academic research

What is an example of positive consumption externalities?

Vaccinations to protect public health during a pandemic.

How do externalities cause market failures?

• Disrupt the efficient functioning of markets

• Externalities lead to a net loss of social welfare

• Externalities can lead to market failure because the prices and quantities determined by supply and demand in the market do not account for these benefits or external costs

What are private costs?

Internal costs faced by the producer or consumer directly involved in a transaction. e.g. the private cost of owning and running a car/vehicle.

What are external costs?

Occur when the activity of one agent has a negative effect on the wellbeing of a third party. They impose costs on other agents. This causes social cost > private cost

What are private benefits?

The benefit, satisfaction or utility than an individual agent such as a consumer or a business derives from producing or consuming something.

What are external benefits?

Include private benefits but also add in the external benefits that might occur from production and/or consumption

What is marginal private cost (MPC)?

The internal cost to a producer or consumer from supplying or consuming one extra unit of good or service.

What is marginal private benefit (MPB)?

The extra benefit, satisfaction or utility gained by a consumer or producer through consuming or producing one extra unit or good or service.

What is marginal external cost (MEC)?

Cost to third parties (the wider society) from the production/ consumption of an extra unit of output.

What is marginal social cost (MSC)?

Total cost to society arising from producing/ consuming an extra unit of output.

MSC = MPC + MEC

What are the three ways to value externalities?

• Shadow pricing

• Compensation

• Revealed Preferences

What is an example of shadow pricing?

The external cost of road congestion can be calculated by multiplying the number of hours lost by the average wage.

How does compensation act as a way to value externalities and what is an example?

Estimate the cost of ‘putting right’ an externality. e.g. includes the cost of installing double glazing in houses affected by increased road noise from a new motorway.

What is revealed preference and what is an example?

How much people are willing to pay to avoid an externality. e.g. if 200 householders are willing to pay £2000 each to avoid noise the externality is valued at £0.4m

What are some negative externalities from production?

• Air pollution from factories

• Pollution from fertilisers

• Industrial waste

• Noise pollution

• Space junk

• Methane emissions

What are some negative externalities from consumption?

• Particulates from vehicle pollution

• Household waste

• Noise pollution from neighbors

• Air pollution from smokers

• Traffic congestion

• Impact of gambling

• Litter damaging beaches and waterways

What are two welfare effects from negative externalities?

• External costs from air pollution- linked to 40,000 deaths each year (UK) and worsens chronic illnesses

• External costs from urban road congestion- UK is 3rd most congested in Europe, drivers spend around 32hrs a year in congestion during peak times.

When do positive externalities exist?

Exist when third parties benefit from the spill-over effects of production/ consumption.

When does positive externalities occur on a graph?

When social benefits exceed private benefits

What are some positive externalities from consumption?

• Health care services

• Wearing a face mask during a public health crisis

• Subsidised cycle schemes in urban areas

• Public libraries/ community spaces, including parks

• Museums and galleries open access to the general public

• Free school meals/ improved nutritional advice

• Apple orchards that allow bee populations to grow

• People taking up the offer of vaccinations

What are some interventions with positive externalities?

• Government subsidy to the consumer (reduces private cost/ increase real income)

• Government subsidy to the producer

• Government provision and funding

• Behavioural nudges to change consumer behaviour

• Mandatory choices such as compulsory education

When does mixed externalities occur?

When production and/or consumption leads to both external cost and external benefits.

What are mixed externalities also known as?

Partially internalised externalities

What is the effect on 3rd parties in a mixed externality?

Has both beneficial and harmful effects

Why are mixed externalities more complex to address?

Policymakers need to consider both types of effects and find ways to encourage the positive aspects while mitigating the negative ones.

What are negative externalities of the use of cars in an urban area?

• Air pollution

• Traffic congestion

• Noise pollution

What are positive externalities of the use of cars in an urban area?

• Convenience and mobility to individuals

• Easily access jobs, education and services

• Contributes to economic activity through transportation and supports various industries such as automotive manufacturing

What are negative externalities of the use of pesticides in agriculture?

• Harmful to environment, contaminate groundwater and nearby water bodies, creating a cost

• Can harm non-target organisms like beneficial insects, birds and aquatic life

What are positive externalities of the use of pesticides in agriculture?

• Increased agricultural productivity

• Higher crop yields

• Contributes to food security, lowers food prices and supports livelihood of farmers

Why is carbon price volatility a limitation of using carbon trading?

It is a barrier to investments because of higher risk. A carbon task provides more certainty to businesses affected.

Why is carbon leakage a downside of using carbon trading?

Occurs when companies move production to countries with lower carbon prices, to avoid paying for carbon credits. Meaning some companies wont be affected by taxes imposed.

What is a carbon tax?

It is a tax on the consumption or production of goods and services, which cause carbon emission

What is the aim of a carbon border tax?

To reduce emissions by placing a tariff on imports from countries with less stringent climate policies.

How does the carbon border tax work?

It requires importers to pay a fee for the carbon emissions embedded in the products they are exporting.

What are three advantages/ justifications to Europe introducing a carbon border tax?

• Encourages countries with weaker climate policies to take action to reduce carbon emissions.

• Protect domestic industries: helps prevent carbon leakage

• Green tariffs generate revenue for climate action: can be then used to fund climate action such as renewable energy.

What are three drawbacks to Europe introducing a carbon border tax?

• Could lead to trade disputes if it is seen as a protectionist measure. Will hamper exports from poor countries.

• Increase cost of imported goods, which could lead to higher consumer prices. This will have a regressive impact on low-income families.

• Simpler to have a global carbon price, which would be levied on all companies per tonne of CO2 produced as a result of their operations. But an agreement is a long way off.

What are some government regulatory interventions with externalities?

• Smoking bans in public places

• Minimum age laws for tanning salons/ gambling

• Maximum CO2 emissions for new vehicles

• Recycling directives for household appliances

• Banning wet wood for use in indoor wood burners

• Fishing quotas to protect stocks

What is the rationale behind government regulations with externalities?

They act as a spur for business innovation to cut the level of carbon emissions and can be gradually toughened each year which will help stimulate investment.

What are disadvantages form adding regulations to industries?

• High cost of enforcement/ administration of strict laws

• Can lead to unintended consequences/ this causes government failure

• The cost of meeting regulations can discourage small businesses and lead to less competition in markets