Chapter - 13

EXTERNALITIES

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

 Externalities are the spillover effects of consumption or
production. These are third party effects ignored by the price
mechanism.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

• Negative Externalities (External cost) - Negative spillover effects of consumption or
production. For example, air pollution, noise pollution, traffic congestion, smoking and
alcohol abuse causing healthcare expenditure of the government to rise. Government
makes policies to reduce negative externalities.

• Positive Externalities (External benefit) - Positive spillover effects of consumption or

production. For example, healthcare, education and training, vaccine

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

• Public goods - Goods that have the characteristics of non-rivalry and non-excludability. For
example- street light, defense, law & order. Public goods are financed by taxation.

• Merit goods - Goods which are regarded as beneficial to the society and is expected to be
inadequately produced by the public sector. example- education and healthcare

• De-merit goods - Goods which are regarded as socially harmful and will be over-produced
and over-consumed if left to the private sector. For example- cigarettes and alcohol.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

 • Private cost - It is the cost of an economic activity to individuals and firms. For
example, cost of production, raw materials, price paid by consumers.
Social Cost = Private cost + External cost

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

• Private Benefit - It the reward of an economic activity to individuals and firms.
For example, revenue by firms.
Social Benefit = Private Benefit + External Benefit

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

Q.1 A new airport is being constructed in your city, Analyze the social cost and benefit of
such a construction?
Social Cost is the accumulation of private and external cost. Private cost is the cost of an economic
activity to individuals and firms. The private cost of this airport construction would be cost of
production, raw materials, wages paid to the labours. External costs are the spillover effects of
consumption or production. These are third party effects ignored by the price mechanism. The
external cost of this airport construction may be the increase in noise and sound pollution due to
this construction.
Social benefit is the accumulation of private and external benefit. Private benefit is the reward of an
economic activity to individuals and firms. In this case it would be the revenue of the construction
company. External benefit is the positive spillover effects of consumption or production. In this case
it would be infrastructure development of the city and the ease to air travel.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

 MARKET FALIURE

It is a situation where market leads to inefficiency, thus leading to a net welfare loss for society.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

□Reason for Market Failure:
1) Externalities may not be taken into account while consumption and production of
goods and services. This can lead to over production in the market where negative
externalities exist.
2) The private sector is unlikely to provide public goods such as street lights due to the
free rider problem.
3) Imperfect information exists when people lack knowledge to make informed choices
and this leads to misallocation of resources.
4) Lack of competition may arise due to monopolies, which can exploit consumers with
higher prices.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

□Government policies to reduce Market Failure:

1) Indirect Taxation
• Imposition of taxes will increase production cost and the price of the product will
rise. Higher prices will discourage production and consumption of a good with
negative externalities.

• Evaluation
i) It is difficult to quantify and attach a monetary value on the external cost.
ii) May not be effective if the magnitude of tax is low.
iii) If PED for the product is inelastic (tobacco, oil) then consumption will only fall less than
proportionately following an increase in price.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

 □Government policies to reduce Market Failure:

2) Government Regulation
• Government can pass rules and regulations to protect the environment and take
legal actions if anyone disobeys them. For example, banning smoking in public,
forcing firms to install pollution reducing equipment.

• Evaluation
i) It is difficult and expensive for government to monitor and enforce.
ii) Firms must be large enough to have some impact.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

□Government policies to reduce Market Failure:

3) Subsidies
• It is a grant given by the government to reduce production cost. They may be
given to economic activities which reduce external cost such as firms that install
pollution reducing equipments, public transport, renewable energy, recycling and
waste management plans.

• Evaluation
i) It incurs opportunity cost for the government as the money could have been used in
other places instead of being spent on providing subsidies.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

 □Government policies to reduce Market Failure:

4) Tradable pollution permit

• It is an allowance on the amount of pollution firms may emit. Firms that emit below their limit
can sell surplus permits to other firms. Thus it acts as a profit incentive for firms to reduce
pollution.

• Evaluation
i) It is difficult to qualify external cost and therefore to set the right number of permit.
ii) It increases government expenditure of monitoring and enforcement.
iii) If many permits are issued, there will be little incentive for firms to invest into pollution
reducing technology.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

□Government policies to reduce Market Failure:

5) Road Pricing
• It is a bundle of various direct charges levied for the usage of roads for
example, London congestion charge increases the cost of motoring during peak
hours and thus reduce the demand for road usage. It encourages motorists to
drive at off-peak hours.
Revenue raised from the charge can be spent on reducing congestion further by
developing transport infrastructure.

• Evaluation
i) The implementation of a road pricing scheme can be very expensive and depends
on the state technology available.
ii) It will not be successful if the magnitude of charge is low.

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13

 THE END

AUNTORIP KARIM - CLASS VIII ECONOMICS - CHAPTER 13