Positive and Negative externalities on prod and cons

• Externality


  Cost or benefit a third party receives from an economic transaction outside of the market mechanism.
• Negative externalities are caused by demerit goods.
• Negative externalities are associated with information failure, since consumers are not aware of the long-run implications of consuming demerit goods.
• Demerit goods are often overprovided. E.g. cigarettes.
• Positive externalities are caused by merit goods.
• Positive externalities are associated with information failure, because consumers do not realise the long-run benefits to consuming the good.
• Merit goods are underprovided in a free market.
• The extent to which a market fails involves a value judgement, so it is hard to determine what the monetary value of an externality is.
• Private costs


  Determine how much the producer will supply; which refers to the market price which the consumer pays for the good.
• Producers are concerned with private costs of production, e.g. rent, raw materials, machinery and labour
• Social costs


  PC + EC
• External costs increase disproportionately with increased output.
• Private benefit


  The price the consumer is prepared to pay determines the private benefit from consuming a good. This could also be a firm's revenue from selling a good.
• Social benefit 


  PB + EB
• Social optimum 


  MSC = MSB => point of maximum welfare
• The market equilibrium, where supply = demand at a certain price, ignores negative externalities. This leads to over-provision and under-pricing.
• Negative externalities


  MSC>MPC of supply
• The absense of property rights leads to externalities in both production and consumption and hence market failure.
• Markets become inefficient where there are no property rights. 


  E.g. it is practically impossible to establish property rights on goods such as sea water and air. This means that free-riders can have unlimited access, which results in the exploitation of the good.