Externalities (Edexcel 9-1)

Economic activity, such as transportation of resources or goods, will have effects on the business as well as those outside. There are spillover effects that are caused by production and consumption.

External Costs Of Production

Production activity may result in costs that are incurred by third parties. Neither owners or employees, they may be individuals, organisations, local residents or the environment. External costs are the spillover effects of production. These can be :

  • Air Pollution

  • Noise Pollution

  • Water Pollution

  • Resource Depletion

  • Overcrowding

  • Traffic Congestion

External Benefits Of Consumption

Consumption of certain goods can have positive spillover effects. Which are called external benefits and are enjoyed by third parties. Examples of these are :

  • Education -

Education is likely to benefit those who attend school and universities, as they can get jobs, earn money, and enjoy a better quality of life. Wider society may also benefit due to the increase in technical and qualified jobs being occupied. This results in producing levels to rise and standard of living to rise. It is argued that higher levels of education will lower unemployment, increase political participation, and improve household mobility.

  • Health Care -

Health care will benefit individuals as their personal health improves. They can feel less pain, return to work and enjoy life more. However, consumption of healthcare and its benefits and effects can be felt by third parties. Healthier individuals can work more effectively, producing more economic output and paying taxes.

  • Vaccinations -

An individual benefits directly from a vaccination. Third parties will also benefit as vaccination decreases the chances of contracting diseases.

Social Cost

The consumption and production of a good can be divided into external cost and private cost. Private costs are met by people who consume or produce a good. Ex : a smoker may face the private cost of the price of the cigarette, while external cost third parties may face is the health risk and discomfort of inhaling cigarette smoke.

The private cost in production might be the financial cost of the project, while the external cost incurred can be :

  • Noise from the construction on the development site.

  • Congestion caused by construction vehicles and workers arriving at the site.

The cost to society from the entire economic activity is called social cost. It is made up of the private cost and external costs.

Social Costs = Private Costs + External Cost (Negative Externalities)

Social Benefits

The production or consumption of a good can also be divided into private benefits and external benefits. Those who produce or consume goods enjoy private benefits. In production, the private benefit may be the rent enjoyed by the construction of a building to the developer. The external benefit may be the new housing facility and creation of employment due to the building.

The benefits to society as a whole of an economic activity are the social benefits, it consists of private benefits and external benefits.

Social Benefits = Private Benefits + External Benefits (Positive Externalities.)

Government Policies To Deal With Externalities

A government will want to discourage economic activity with negative externalities and encourage those with positive externalities. This is done by :

  1. Taxation

  • Taxation can reduce external costs. If heavy tax is levied on a chemical firm that is producing damaging emissions, their production cost will rise and prices will rise. This will drive demand for their products lower and an overall reduction in pollution. Taxes may also be used to limit consumption of harmful products. If taxes are placed on cigarettes, supply should reduce and prices will be higher. Resulting in low demand. However, there may not be a significant decrease in demand for cigarettes due its addictive nature.

  1. Subsidies

  • Governments can offer subsidies and financial rewards to firms that reduce external costs. A subsidy might be given to a plastic recycling plant. As this can further encourage recycling of plastic products for households and firms. Subsidies are also given to firms that generate external benefits. If subsidies are given to solar energy producers, there will be an increase in supply of solar energy and this will stimulate more demand for solar energy. This will provide benefits to the environment as clean energy will be supplied. Subsidies can be given to university students as grants, leading the wider society to benefit from a better-educated population. However, a problem with subsidies is the opportunity cost. Money needed for subsidies that reduce external costs or raise external benefits or can be better spent on other government projects such as; healthcare and better infrastructure.

  1. Fines

  • A system of fines can be used to reduce external costs. Fines may be imposed on those who damage the environment or disturb communities. Fines may be implemented on firms that dump waste in the ocean, tourists who litter or mini-buses that play loud music.

  1. Government Regulation

  • Pressure on the government to pass more legislation to protect the environment has emerged from the growing concerns on global warming. Many countries have laws designed to protect the environment that are directed at firms and reduce external costs of production. Laws can be set up to monitor and control pollution. It also lays down regulations relating to polluted land, abandoned mines, national parks, air quality, and waste. However, it is not easy to get businesses to obey the regulations if placed. Governments may lack the commitment or resources to enforce laws. Some companies responsible for pollution may be well-resourced and powerful that can stand firmly against legal-disagreements.

  1. Pollution Permits

  • Pollution permits can be issued to companies. These documents give the businesses the right to produce a certain amount of waste material. These permits are tradable. Meaning they can sell the permits to other businesses when they discover a method of not producing waste or polluting. Therefore, a business struggling to minimise its waste can buy a permit and dispose of it legally. This creates an incentive in the market to introduce new technology that reduces waste. Since they will be able to sell their permits, which raises profit. However, governments have to decide how many pollution permits to issue. This is determined by carbon dioxide reduction deals each country has signed up to. Pollution is difficult to measure and the government may give out too many of these permits. The costs of permit administration are too high and companies may falsify their pollution levels if it is expensive or difficult to measure.

Key Terms or Terminology :

  • External Costs - Negative spillover effects of consumption or production - they affect third parties in a negative way.

  • External Benefits - Positive spillover effects of consumption or production - they bring benefits to third parties.

  • Private Costs - Costs of economic activities to individuals and firms.

  • Social Costs - Costs of an economic activity to society as well as a firm or individual.

  • Private Benefits - Rewards to third parties of an economic activity, such as consumption or production.

  • Social Benefits - Benefits of an economic activity to society as well as to the individual or firms.

Questions

  1. What is the difference between external costs and external benefits?

  2. What are some of the external costs of waste disposal?

  3. Explain the external benefits of services such as education and healthcare.

  4. Give the formula for Social Cost & Social Benefits .

  5. What is meant by social cost?

  6. Explain how government regulation may be ineffective when dealing with externalities.

  7. What are some problems with pollution permits that override the benefits?

  8. How are taxation and subsidies useful when dealing with externalities?