1.1.6 Externalities
External Costs of Production Definition - Syllabus 1.1.6 (a)
Externality = Consequence of an economic activity that affects third parties not involved in the production and/or consumption of a good/service, which is not reflected in the market prices.
External costs (negative externalities) = Negative spillover effects of consumption or production to third parties. These are the costs imposed on society and others due to a good/service’s consumption or production negatively affecting third parties.
Spillover effect = Effect that 1 situation/problem has on another situation
External Costs Examples - Syllabus 1.1.6 (b)
Use WANTOR acronym:
Water Pollution
Damage to marine ecosystems; cost of decreased yield in commercial fishing
Medical service costs as polluted water damages public health
Economic output costs (sick employees due to water pollution) → lower productivity
Air Pollution
Medical service costs as air pollution can lead to chronic respiratory illnesses
Economic output costs (sick employees due to air pollution) → lower productivity
Damage to biodiversity and sustainability
Cost of decreased agricultural yield
Noise Pollution
Medical service costs as noise pollution can cause high blood pressure, stress, hearing impairments, and disturb mental health.
Economic output costs (sick employees due to noise pollution) → lower productivity
Cost of decreased rent values (people don’t want to live in excessively noisy areas)
Traffic Congestion
Damage to ecosystems due to climate change caused by excess CO2 emissions.
Air pollution
Noise pollution
Medical service costs as traffic congestion leads to higher likelihoods of accidents
Economic output costs as employees may not be as punctual to work
Costs of extra taxi/transportation fees due to longer waiting time
Disturbs wellbeing (people can become stressed, annoyed, or agitated due to traffic)
Overcrowding
Medical service costs as overcrowding/stampedes can lead to deaths.
Economic output costs as employees may not be as punctual to work
Noise pollution
Disturbs wellbeing (people can become stressed, annoyed, or agitated due to overcrowding)
Resource Depletion
Cost of decreased economic yield
External Benefits of Consumption Definition - Syllabus 1.1.6 (c)
External benefits (positive externalities) = Positive spillover effects of consumption or production to third parties. These are the benefits enjoyed by society and others due to a good/service’s consumption or production positively benefiting third parties.
External Benefits Examples - Syllabus 1.1.6 (d)
Education
Private benefit: educated students can get better jobs, earn more money, and enjoy a higher quality life.
External benefit: Education → ↑ skilled and socially useful jobs (e.g. doctors, teachers, etc) i.e. ↑ skilled labour force → ↑ productivity and ↑ living standard → Benefits to society. It could also improve household mobility, political participation, whilst lowering unemployment.
Healthcare
Private benefit: Personal health improves → less discomfort experienced → can return to work and enjoy life.
External benefit: Healthier people → ↑ efficiency → ↑ economic output and ↑ tax contributions.
Vaccinations
Private benefit: Personal immunity to an infectious disease
External benefit: ↓ probability of non-vaccinated people contracting disease because ↓ people can transmit the disease due to ↑ vaccinations (and therefore ↑ general immunity)
Social Costs & Social Benefits - Syllabus 1.1.6 (e)
Social Cost = Total costs of an economic activity to society as a whole as well as the individual(s) and/or firm(s). It’s usually for production and firms.
Social Cost = Private Cost + External Cost
Private Cost = Cost of an economic activity to the individual(s) and/or firm(s). E.g. Costs businesses incur due to production of a good/service such as hiring machinery, labour, material costs, etc.
Example: Private cost of smoker maybe US$100/month spent on cigarettes, external cost is discomfort and health risk a third party might be exposed to due to 2nd-hand smoking (e.g. a US$200/month medical fee for illnesses instigated by 2nd hand smoking) → social cost of US$100 + US$200 = US$300/month
Social Benefit = Total benefits of an economic activity to society as a whole as well as the individual(s) and/or firm(s). It’s usually for consumption and consumers.
Social Benefit = Private Benefit + External Benefit
Private Benefit = Benefits of an economic activity to the individual(s) and/or firm(s).
Example: Private benefit of cycling to work is saving £3/day by not taking public transport and getting good cardiovascular exercise. External benefit of cycling to work is less air pollution and traffic congestion (e.g. saving £5/day from everyone not being late to work as well as being productive due to less traffic congestion) → social benefit of £3 + £5 = £8/day.
To see whether an economic activity is worth it or not, you can compare the social costs and social benefits, though the exact quantities of money gained/lost may be difficult to quantify.
Government Intervention for Externalities
Governments discourage economic activities resulting in negative externalities and encourage economic activities resulting in positive externalities.
Use STRFP acronym:
Subsidies = Money directly paid by the government to producers for encouraging production of a good/service, or in some cases to the good/service’s consumers.
Reduces cost to provide higher consumption and production.
Offered to firms as incentive to reduce external costs.
E.g: Firms may receive subsidy if it builds a plastic recycling plant; government uses subsidies here to encourage consumers/firms to recycle their plastic.
Offered to firms as reward/encouragement to generate more external benefits, especially for public and/or merit goods.
E.g: Excelling university students may receive government grants/scholarships; government uses subsidies here to encourage more people into higher education, as this creates the external benefit of a better-educated population → higher skilled and higher efficiency labour force.
Taxation = Fee charged by the government on a good/service, income, or economic activity
Direct tax = Tax levied on the tax payer’s income or profits.
Indirect tax = Tax levied on goods, services, and spendings, rather than directly on the tax payer’s income or profits. E.g: VAT.
Imposed on firms to reduce external costs of production.
E.g: Tax imposed on chemical firm producing damaging emissions → ↑ production cost → ↑ selling price → ↓ demand → ↓ pollution and damaging emissions
Imposed on consumers to reduce external costs of consumption
E.g: Tax imposed on cigarettes → ↑ production cost → ↓ supply and ↑ price → ↓ demand and ↓ third parties affected by smoke (however, cigarettes are addicting → “necessity” → inelastic demand → demand may not fall much even when prices rise due to tax)
Regulation
Governments can establish wide ranges of legislation, standards, and legal controls.
Businesses disobey law → Consequences like written warnings, heavy fines, business closure, etc.
Governments may lack commitment and/or resources for law enforcement (powerful, well-resourced multinationals generating external costs may stand firmly against governments during legal disagreements).
Fines = Money that must be paid as a punishment for not obeying a rule/law
Imposed to reduce external costs of consumption and production.
E.g: In 2016, China ordered 6 unnamed companies to pay a total of US$26,000,000 for polluting the environment by discharging waste chemicals into rivers.
Fines VS Taxes:
Taxes are collected to source government revenue and support costs of their activities while fines are collected as a penalty to discourage certain undesirable behaviors.
Pollution permit (a.k.a. Tradable permit) = Government-issued document allowing firms to discharge a certain amount/quota of polluting material to the environment.
Firms pollute more than permitted → legal prosecution against them
Pollution permits are tradable → Unused/partially-used pollution permits can be sold to other firms → incentive to find ways of reducing pollution (as pollution permits can be sold to others for cash/profit) and others struggling to control pollution can buy a permit to legally discharge more polluting material.
Government must decide how many pollution permits to give and pollution is hard to measure → may under or over allocate.
↑ pollution permit cost (firms may disguise their pollution permit to be more than it actually is if it’s difficult to measure, so they can sell it for more cash and therefore earn more profit/revenue).