Externalities

define negative production externality

A negative externality is a negative cost on a third caused by the actions of a producer

Draw a negative production externality

Analyse a negative production externality

Firms act in their own self interest and produce at Q1 instead of Q star

This is an over production of this good or service

At Q1 the price is also too low and does not take into account external costs only private costs - this increases the over production and consumption of this good

All this amounts to a misallocation of resources and allocative inefficiency

Define a negative consumption externality

Costs to 3rd parties caused by the actions of consumers

Draw a negative consumption diagram

Analyse a negative consumption externality

Consumers act in their own self interest and don’t take into account the 3rd party costs

This leads to over-consumption of this good/ service

And finally at q1 there is a misallocation of resources and allocative inefficiency

Examples of negative consumption externality

Unhealthy eating and excessive alcohol consumption leads to a heavier burden on health services (Third party)

Define a positive consumption externality

A positive consumption externality is a benefit to a third party caused by the actions of a consumer

Give an example of a positive consumption externality

Getting vaccinated stops you from getting an illness and spreading it to vulnerable individuals

Eating healthy means less hospital trips leading to a lighter burden

Draw a positive consumption externality

Why is there a welfare loss in a positive consumption externality

In the difference between private and social optimum external benefits is greater than external cost and so society misses out on external benefit

Analyse a positive consumption externality diagram

Consumers are self-interested and prioritise their private benefit over social benefit

This leads to an under consumption of this externality

So at Q1 there is an misallocation of resources and there is allocative inefficiency

Define a positive production externality

A benefit to third parties caused by the actions of a producer

What is an example of a positive production externality

Firms offering training schemes this improves a workers skills and then these workers can be poached by other firms benefitting them without setting up training schemes of their own

Or firms copying new innovations after R and D investment from other firms

Draw a positive production externality

Why is there a welfare loss

Because firms are only producing at Q1 instead of Q star society we miss out on q star - q1 and at these quantities social benefit is bigger than social cost so we miss out on social gain

Analyse a positive externality diagram

Firms act in their own self interest and ignore the social benefits and prioritise private benefit

This leads to the under-production of the good or service as firms produce at private equilibrium

This is a misallocation of resources and is allocative inefficient