1.3.2- Externalities

• When there are asymmetric markets, the government provides information to allow people to make informed decisions
• Private costs/benefits


  The costs/benefits to the individual participating in the economic activity
• Social costs/benefits


  The costs/benefits of the activity to society as a whole
• External costs/benefits


  The costs/benefits to a third party not involved in the economic activity
• Merit good


  A good with external benefits, where the benefit to society is greater than the benefit to the individual

  Tend to be under provided by free market
• Demerit good


  A good with external costs, where the cost to society is greater than the cost to the individual

  Tend to be over provided by free market
• Marginal private benefit (MPB)


  The extra satisfaction gained by the individual from consuming one more of a good
• Marginal social benefit (MSB)


  The extra gain to society from the consumption of one more good
• Marginal private cost (MPC)


  The extra cost to the individual from producing one more of the good
• Marginal social cost (MSC)


  The extra cost to society from the production of one more good
• It is difficult to work out the size of the externality as it tends to be placed on value judgements, since it is difficult to monetise external costs
• Many externalities are involved with information gaps, as people are unaware of the full implications of their decisions
• Government interventions to address externalities

  • Indirect taxes and subsidies
  • Tradable pollution permits
  • Provision of the good
  • Provision of information
  • Regulation
• negative production externalities


  occur when social costs are greater than private costs, so the market will produce more than the socially optimal amount. It will produce where MPB=MPC (Q1P1). At Q1, MSC is higher than MSB resulting in loss of welfare (orange area). At Q1, external cost is equal to line AB. Economy should produce where MSC=MSB (socially optimum position) at Q2P2.

  Difference between MSC and MPC increases as output increases, external costs grow.

  
• examples of negative externalities of production

  noise pollution from airplanes

  industrial waste
• positive consumption externalities

  occurs when social benefits are greater than social costs so the market will produce less than the socially optimal amount. Market left to itself produces where MPB=MPC at Q1P1, will not consider benefits to society. If market considers benefits to society it would produce where MSB=MSC at Q2P2. Failure of market to consider external benefits has lead to misallocation of resources and so underproduction of Q1-Q2- leads to welfare loss (orange area). Line AB is external benefit, this grows as output increases

  
• examples of positive externalities of consumption

  healthcare

  education