1.3.2 Externalities

• Externality


  The cost or benefit a third party receives from an economic transaction outside of the market mechanism
• Types of externalities


  • Positive (external benefits)
  • Negative (external costs)
• Negative externalities


  Caused by demerit goods, associated with information failure, consumers unaware of long-run implications, usually overprovided
• Demerit goods


  • Cigarettes
  • Alcohol
• Negative externality of cigarettes

  Second-hand smoke or passive smoking
• Positive externalities


  Caused by merit goods, associated with information failure, consumers unaware of long-run benefits, underprovided in free market
• Merit goods


  • Education
  • Healthcare
• Positive externality of education


  Higher skilled workforce
• The extent to which the market fails involves a value judgement, so it is hard to determine the monetary value of an externality
• Private costs


  Producers are concerned with, e.g. rent, cost of machinery, labour, insurance, transport, raw materials
• Social costs


  Private costs plus external costs
• External costs


  Shown by vertical distance between marginal social cost (MSC) and marginal private cost (MPC) curves
• As output increases


  External costs increase disproportionately
• Private benefit


  Consumers are concerned with, determined by price they are prepared to pay
• Social benefit


  Private benefits plus external benefits
• As output increases


  External benefits increase disproportionately
• Social optimum position


  Where MSC = MSB, point of maximum welfare
• At the free market equilibrium, there are excess social costs over benefits between Q1 and Qe
• Deadweight welfare loss


  The output where social costs > private benefits
• The market fails to account for negative externalities, reducing welfare in society
• External benefit example


  Decline of diseases and healthier lives of consumers through vaccination programmes
• External benefits are underprovided and under consumed in the free market, where MSB>MPB</b>
• Government policies for negative externalities

  • Indirect taxes
  • Subsidies
  • Regulation
  • Provide the good directly
  • Provide information
  • Property rights
  • Personal carbon allowances
• Indirect taxes


  Reduce quantity of demerit goods consumed, increase price, internalise the externality
• Subsidies


  Encourage consumption of merit goods, include full social benefit in market price
• Regulation


  Enforce less consumption of a good, e.g. minimum school leaving age, compulsory recycling
• Provide the good directly


  Government provides public goods underprovided in free market, e.g. education
• Provide information


  So consumers and firms can make informed economic decisions
• Property rights


  Encourage innovation, protect new ideas and allow entrepreneurs to earn profit
• Personal carbon allowances


  Tradeable, firms and consumers can pollute up to a certain amount and trade what they do not use