8.4

• What is an externality?

  Cost or benefit to a third party
• What types of externalities exist?

  Positive and negative externalities
• What causes negative externalities?

  Demerit goods like cigarettes and alcohol
• Why are negative externalities associated with information failure?

  Consumers are unaware of long run implications
• What are merit goods associated with?

  Positive externalities and information failure
• Why are merit goods usually underprovided?

  Consumers do not realize long run benefits
• What complicates the determination of externality values?

  The extent of market failure involves value judgement
• Why is it hard to determine a monetary value of an externality?

  It involves subjective value judgments
• Private Costs 

  • Producers are concerned with private costs of production. This determines how much the producer will supply. It could refer to the market price which the consumer pays for the good.
• Social Costs

  • This is calculated by private costs plus external costs. On a diagram, external costs are shown by the vertical distance between the two curves. It can be seen that marginal social costs (MSC) and marginal private costs (MPC) diverge from each other. External costs increase disproportionately with increased output.
• Private benefit

  • Consumers are concerned with the private benefit derived from the consumption of a good. The price the consumer is prepared to pay determines this. Private benefits could also be a firm’s revenue from selling a good.
• Social benefit 

  •  Social benefits are private benefits plus external benefits. On a diagram, external benefits are the difference between private and social benefits.
• Social Optimum Position 

  • This is where MSC = MSB and it is the point of maximum welfare. 
  • The social costs made from producing the last unit of output is equal to the social benefit derived from consuming the unit of output. 
• What are external costs of production?

  Costs occurring from production or consumption
• How are external costs represented in a graph?

  By the vertical distance between MSC and MPC
• What does market equilibrium ignore regarding external costs?

  Negative externalities affecting supply and demand
• What is the consequence of ignoring negative externalities in market equilibrium?

  Leads to over-provision and under-pricing
• What is the relationship between MSC and MPC with negative externalities?

  MSC is greater than MPC of supply
• What does an excess of social costs over benefits indicate?

  Free market equilibrium is inefficient
• What is the area where social costs exceed private benefits called?

  Deadweight welfare loss
• How is deadweight welfare loss represented in a diagram?

  By a triangle in the graph
• What does the market fail to account for regarding negative externalities?

  Consumption effects that reduce societal welfare
• What would happen to welfare in society if negative externalities are left to the free market?

  Welfare would be reduced in society
• External benefits of production

  • Since consumers and producers do not account for them, they are underprovided and under consumed in the free markets, where MSB>MPB. This leads to market failure. The triangle in the diagram shows the excess of social benefits over costs. It is the area of welfare gain.
• Absence of property rights

  • Markets become inefficient when there are no property rights. The moral hazard assumes someone else will pay the consequences for a poor choice. 
  • Scarce resources could be over-used or exploited, this could be because they aren’t protected by property rights.