Externalities

Sunday, 2 May 2021 2:29 pm

• Definition
○ Externalities occur when there are costs or benefits imposed on a third party no
transition
○ The market usually captures private costs and benefits associated with productio
goods and services but there are many cases where the market ails to capture e
a transactions.
○ They can be negative (cost to a third party) or positive (benefit to the third party
production or consumption.
○ Negative Externalities
§ A negative externality occurs when goods are sold at prices that do not inc
the production or consumption of a good.
§ The private cost (purchase price) is less than the social cost because the so
from the operation of the price mechanism so the market doesn’t compen
affected
□ Therefore social costs exceed private costs. The private costs are th
itself. The producer will always take this into account.
® So the market allocation of resources will be socially inefficien
§ Market price only takes into account the value consumers place on the las
to firms of producing it. So this only covers the direct cost of production a
account the social impactl. When an externality is present this upsets the b
reflected in price consumers will demand too much and too much will be p
§ Negative externalities always result in over consumption or production
§ Diagram
□ Negative Consumption Externality

®
ot involved in the economic

on and consumption of
external benefits and costs of

y) and can come from the

clude the full social cost of

ocial costs were externalised

nsate to those who were

hose incurred on the firm

nt
st unit of output and the cost
and doesn’t take into
balance. So if this is not
produced or consumed.
 ®

□ Negative Production externality

®
 ®

□ Consumption Vs production
® A Consumption externality arises from the consumption of the
® A production externality arises from production (pollution)
§ Government action to correct negative externalities
□ Regulation
® Governments can reduce the effects of externalities by passin
regulate problematic behaviour
® This is a command and control approach that works well for si
® This means regulations are often used in cases where the exte
individual benefits like pollution.
◊ Essentially a black and white situation where there is a c
them
□ Taxes
® Another policy that can be implemented is taxes.
® Taxes on market activities that generate negative market exte
taxes.
® Taxes cause a reduction in consumption or production and the
put right the costs imposed by the externalities.
e good (smoking)

ng new laws that directly

imple or extreme cases

ernal costs far outweighs the

correct answer according to

ernalities are called Pigovian

e tax revenue can be used to

 ® Another policy that can be implemented is taxes.
® Taxes on market activities that generate negative market exte
taxes.
® Taxes cause a reduction in consumption or production and the
put right the costs imposed by the externalities.
◊ For example ciggarets are taxed and the money goes to
people that smoke.

○ Positive Externalities
ernalities are called Pigovian

e tax revenue can be used to

health and hospital costs for

○ Positive Externalities
§ A positive externality is a benefit that is enjoyed by a third party as a resul
§ Individuals who benefit are considered free-riders, but it may be in the int
encourage free riders to consume goods with generate substantial externa
§ These are goods that are beneficial or socially desirable and are under con
§ Merit Goods
□ Merit goods and services are under produced by markets because in
highly enough to pay for them or because private firms cannot achie
producing.
□ Diagrams
® Consumption

® Production

◊
lt of an economic transaction
terest of society to
al benefits to society
nsumed or underproduced

ndividuals don’t value them

eve normal profits from
 ◊

□ Examples
® Public Hospitals
® Public Schools
® Housing for low income earners
® Vaccination programs
® Libraries art galleries museums.
□ Government Policy to correct Positive externalities.
® Positive externalities result in benefits to third parties so the g
increase consumption or increase production.
® It achieves this via subsidies, these are grants that incentivise

® The subsidy covers the gap between P2 and P3. and the origi
subsidy is P1 then the subsidy covers between demand (p) and
and students pay P1.
government wants to

consumption or production.

inal price without the

d demand (s) and unis get P2
® The subsidy covers the gap between P2 and P3. and the origi
subsidy is P1 then the subsidy covers between demand (p) and
and students pay P1.

® Subsidy covers P2 to P3 and incentivised producers to produce

inal price without the
d demand (s) and unis get P2

e more of a given good.