3.2 EXTERNALITIES
An externality is something produced in production or consumption, which is received in production or consumption often by an unwilling third party who is outside of the market. They can be either positive or negative and are known as spill over effects.
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They occur when there is a divergence between the private and social costs and benefits. The market will produce at the equilibrium where private costs and benefits are equal. The marginal private benefit is the demand curve as individuals demand a good because they receive utility and benefit from consuming it. The supply curve is the marginal private costs. Supplies will supply a good when the costs are compensated through a price that covers these private costs. When we are at an equilibrium, the marginal private benefit and marginal private costs are equal; neither consumers or producers will want to consume or provide any more or any less of the good. However, both consumers and producers have failed to consider what the social cost and benefit of consuming the goods is to society. The optimal level of output will be where the social cost and social benefit are equal. We can have two types of externalities; positive and negative ones.
Negative Externality
Negative externalities occur when someone is made worse off by the production or consumption of a good and they are not properly compensated.
A negative externality is likely to result in the overproduction of good because they only take into account private costs and benefits and fails to look at the social costs and benefits of production. The government would want to reduce the quantity to the level that is socially optimum and can do this through legislation, taxation or providing more information. With the pollution example, the government could either tax the producer in order to restrict supply or they could pass a law that forces the firm to internalize the externality and reduce the impact that the firm is having on the environment. If the negative externality comes from the consumption of the good the firm could tax demand, which will raise the price and reduce the amount that is demanded. The government currently does this for petrol where there are pollution issues and alcohol where there are health issues. For alcohol, the government could provide more information to consumers. If consumers are fully aware of the costs of consumption they may happily reduce their demand on their own accord meaning that there is no need for strong government intervention. However, sometimes individuals do not like to listen to the government and instead believe they know what is best and do what they like.
Negative externalities occur when someone is made worse off by the production or consumption of a good and they are not properly compensated.
- One example of a negative externality is smokers smoking in public places. Smokers produce smoke that is then breathed in by individuals who are around the smoker. The smoker only takes into account the private cost and benefit of their actions and fails to observe the social cost, which is other people breathing in smoke. The externality is forced upon them because other individuals in the room do not have a choice; this is known as the external cost. It is a negative externality because the more smoke you breath in the higher the chance is of having lung cancer later on in life. The government has overcome this issue in pubs by imposing bans meaning smokers have to go outside if they want to smoke.
- Another example is pollution by firms. If a firm produces a good and there is a by-product they may choose to dump it in a local river. This could cause the river to loose biodiversity and could cause the population to have water issues in gaining enough clean water. If there were no repercussions for the business, then they would continue carrying out this practice. However, governments try to create laws which try to encourage firms to internalize the externality and if they fail to do this the firm will be fined.
- Alcohol is another example of a negative externality as the consumption can increase the chances of individuals developing cancer and other associated issues with drinking too much. These affect both the consumer of alcohol and the government because government expenditure of healthcare will increase if individuals become ill and have health issues. These social costs are not included in the price because without government intervention the market would clear where private costs and benefits are equal. With alcohol the private costs are lower than the social cost and this is why we would get overconsumption compared to the socially optimal level.
A negative externality is likely to result in the overproduction of good because they only take into account private costs and benefits and fails to look at the social costs and benefits of production. The government would want to reduce the quantity to the level that is socially optimum and can do this through legislation, taxation or providing more information. With the pollution example, the government could either tax the producer in order to restrict supply or they could pass a law that forces the firm to internalize the externality and reduce the impact that the firm is having on the environment. If the negative externality comes from the consumption of the good the firm could tax demand, which will raise the price and reduce the amount that is demanded. The government currently does this for petrol where there are pollution issues and alcohol where there are health issues. For alcohol, the government could provide more information to consumers. If consumers are fully aware of the costs of consumption they may happily reduce their demand on their own accord meaning that there is no need for strong government intervention. However, sometimes individuals do not like to listen to the government and instead believe they know what is best and do what they like.
Positive Externalities
A positive externality is a benefit that is enjoyed by a third party as a result of an economic transaction. Merit goods (discussed in the next section) are goods which generate a positive externality. One example is healthcare and the vaccines against deadly diseases. The more individuals who take this vaccine the greater the benefit is for others in society as they have a reduced chance of contracting the disease. This means that if you had to pay for the vaccine then some may choose not to because enough other people in society have it. The government overcomes this by making these vaccinations free.
Economic activities that produce positive externalities should be encouraged and there is a role that the government can play. There are two strategies that governments can introduce.
Supply
One is to affect the supply of positive externalities. Governments can give grants and subsidies to producers of goods and services that generate positive externalities. The grants and subsidies reduce the cost of production, which encourages more supply, which in turn increases the level of output produced. This is the case for roads, bridges, and airports. Sometimes the government will take full ownership and produce the goods and services themselves, such as healthcare in the UK, education and social housing.
Demand
A variety of different policies can be used to increase the level of demand:
As individuals do not see the benefit of consumption or firms aren’t producing enough it results in the economy producing a less than a socially efficient output. There is under production.
A positive externality is a benefit that is enjoyed by a third party as a result of an economic transaction. Merit goods (discussed in the next section) are goods which generate a positive externality. One example is healthcare and the vaccines against deadly diseases. The more individuals who take this vaccine the greater the benefit is for others in society as they have a reduced chance of contracting the disease. This means that if you had to pay for the vaccine then some may choose not to because enough other people in society have it. The government overcomes this by making these vaccinations free.
Economic activities that produce positive externalities should be encouraged and there is a role that the government can play. There are two strategies that governments can introduce.
Supply
One is to affect the supply of positive externalities. Governments can give grants and subsidies to producers of goods and services that generate positive externalities. The grants and subsidies reduce the cost of production, which encourages more supply, which in turn increases the level of output produced. This is the case for roads, bridges, and airports. Sometimes the government will take full ownership and produce the goods and services themselves, such as healthcare in the UK, education and social housing.
Demand
A variety of different policies can be used to increase the level of demand:
- Increase the information available. If consumers are fully informed about the benefits and costs of consumption then they will likely consume more if it has a positive externality. For example, consumers now know that fruit and veg have a variety of health benefits and consumption of these goods has gone up.
- Subsidizsing the good or service. The government gives out loans and grants for tuition fees and maintained costs to students attending higher education. This encourages students to apply and a higher level of enrolment in universities has a positive externality for future generations by increased taxation from higher incomes, innovation and R&D, more productive workforce etc… the government thinks that some subjects like medicine and physiotherapy need to be encouraged further (as the external benefit is higher) and these courses are free for students as they are paid for by the NHS.
- Make consumption 100% free, such as health care, for dangerous diseases. Also, schools are free to children.
As individuals do not see the benefit of consumption or firms aren’t producing enough it results in the economy producing a less than a socially efficient output. There is under production.