8.4

• Externality definition

  Producing or consumption of a good causes an impact (cost or benefit) upon a third party not directly related to the transaction
• third party definition

  a person or group besides the two primary partners involved in the market
• a key feature of an externality is that there is no market in which it can be bought or sold - externalities produced and received outside of market, example of missing market
• positive externality definition

  an external benefit that occurs when the consumption or production of a good causes a benefit to a third party, where social benefit is greater that private benefit
• negative externality definition

  an external cost that occurs when consumption or production of a good causes costs to a third party, where social cost is greater that private cost
• positive externality example

  Public park
• negative externality example

  pollution and noise
• property rights definition

  exclusive authority to determine how a resource is used, whether that resource is owned by government or by individuals
• Why are property rights important in economics?

  • prevent overuse or misuse of resources
  • When people own something, they’re more likely to look after it
• when externalities are generated, they’re right to exercise private property rights can disappear
• why does the absence of property rights lead to externalities and hence market failure?

  • markets become inefficient e.g cannot establish property rights on sea water or air: free-riders have unlimited access, results in exploitation of good
  • moral hazard assumes someone else will pay for consequence for a poor choice e.g litter street thinking someone will pick it up
  • scarce resources could be over-used or exploited e.g rainforests depleting and many fish becoming endangered
• free-rider problem definition

  a free-rider is someone who benefits without paying as a result of non-excludability
• free-rider problem extends to both positive and negative externalities:

  1. third party can’t be excluded from gaining benefits from public goods
  2. provider of external benefits cannot charge a price to any free-rider
  3. consumer of an external cost such as pollution or noise cannot charge a price to polluter for the harm they experience
• Production externality definition

  Externality (positive or negative) generated in the course of producing a good or service
• consumption externality definition

  externality (positive or negative) generated in the course of consuming a good or service
• positive production externality definition

  firms production increases well-being of others but firm is not compensated by those others
• positive consumption externality definition

  when an individual‘s consumption increases the well-being of others, but individual is not compensated by those others
• negative production externalities definition

  Cost to third parties caused by a firms production process
• negative consumption externality definition

  Cost to third parties caused by individual consuming good or service e.g smoking
• • in competitive markets, if negative production externalities are generated, goods end up being too cheap or underpriced
  • market creates wrong incentive, as prices under-reflect the cost of production, too many goods are produced and consumed
• Why do markets tend to under-produce goods with positive externalities ?

  • producers do not receive full benefit of their actions
  • Will cause a market to produce less than efficient equilibrium output level
  • Not enough goods being produced and consumed
• Public goods and externalities provide examples of missing markets
• who developed the theory of ‘the tragedy of commons’?

  Garrett Hardin
• when was the ‘tragedy of the commons’ placed forward?

  1968
• what is the ‘tragedy of the commons‘?

  explains how individuals acting in their own self-interest can deplete or spoil a shaved resource, even though it is in everyone’s long term interest to conceive it
• who was Elinor Ostrom?

  first female economist to win Nobel memorial prize in economics (2009), for her work in common resources
• how did Ostrom challenge Hardins views?

  • by arguing individuals and groups could manage their collective resources very effectively - non-tragedy of the commons
  • her work, carried out in Indonesia, Kenya and Nepal, concluded resources like land were managed best when those who benefit live in close proximity
• environmental externalities examples

  pollution of land, sea, rivers and air, and the externalities associated with road use and congestion
• how can government deal with market failures?

  1. taxation
  2. regulations
  3. bans
  4. all three
• governments increasingly making use of behavioural ‘nudges‘ to reduce environmental market failures such as those caused by dumping plastic into rivers and oceans
• how is the ‘tragedy of the commons‘ linked to environmental market failure?

  • natural resources are free and not owned by anyone, people overuse or damage them - without paying for the harm caused
  • This leads to: pollution, overfishing, climate change = all examples of market failure, because the true environmental costs aren’t included in prices
• Assumption that economic agents only consider the private costs and benefits resulting from its markets actions, ignoring any costs and benefits imposed on others
• private cost definition

  costs incurred by individuals or firms directly involved in an economic activity. these are costs of producing a good or service that are borne solely by producer or consumer
• examples of private costs

  • for firms, costs of raw materials, labour and machinery
  • for consumers, price paid for a good or service which they incur to consume the product
• relevance of private costs

  primary costs that decision-makers consider when determining the profitability or affordability of engaging in a transaction
• private benefit definition

  gains or advantages that accrue directly to individuals of firms engaging in an economic activity. these benefits are experienced solely by producer or consumer involved in the transaction
• private benefit examples

  • for a firm, selling goods or services will lead to a profit
  • For consumer, buying a gym membership will improve their health and fitness
• private benefit relevance

  they’re the main incentive driving economic decisions for individuals and firms. they consider these benefits when deciding to consume or produce a good or service
• when does private benefit maximisation occur for economic agents ?

  marginal private benefit (MPB) = marginal private costs (MPC)
• social benefit definition

  total benefits to society from an economic activity, which include both private benefits and any external benefits (or positive externalities) that affect third parties not directly involved in the transaction. social benefit reflects the broader positive impact on society