Introduction to Externalities

Externalities are a form of market failure. Externalities are defined as the spillover effects of the consumption or production of a good that is not reflected in the price of the good. Ex: Production of steel results in pollution being released into the air, but the cost of the pollution to the environment is not reflected in the price of steel.

1. Private Cost

The private cost is the price of an activity to an individual consumer or firm.

2. Social Cost

The social cost is the total cost of an activity not just to the firm but the rest of society as well.

3. Private Benefit

The private benefit is the benefit received by an individual or a firm by consuming and producing a good respectively.

4. Social Benefit

The social benefit is the total benefit to society from an economic activity.

Externalities

Types of Externalities

In a free market, consumers and producers and owners of Factors of Production seek to maximize their own returns, prices and profits play a key role in market mechanisms. Any intervention leads to distorted signals and misallocation of resources.

Negative Externalities of Consumption

When the consumption of a good results in social costs being greater than private costs. They are over produced and over consumed. Example of negative externalities of consumption: a smoker causing second-hand smoke to people around him doesn’t pay for the cost to others (social cost).

Negative Externality of Consumption

The optimal consumption should be Q* at P*, but it’s at Q at P.

Policy to discourage the negative externality of consumption – Indirect taxes, negative advertising, bans.

Positive Externalities of Consumption

When the consumption of a good results in social benefits being greater than private benefits. They are under produced and under consumed. Example of positive externalities of consumption: A farmer landscaping his land makes the countryside better to look at and makes it more pleasant for everyone.

Positive Externalities of Consumption

The optimal consumption should be Q* at P*, but it’s at Q at P.

Policies to encourage positive externalities of consumption – Government provision, positive advertising, regulation encouraging consumption

Positive Externalities of Production

When the production of a good results in private benefits being greater than social benefits. They are under produced and under consumed. Example of positive externalities of production: A vaccination drive in your neighborhood would reduce the chance of you getting infected.Positive Externalities of Production

The optimal production should be Q* at P*, instead its Q at P.

Policies to encourage a positive externality of production- Subsidies, government provision, regulation forcing producers to produce.

Solutions For Positive and Negative Externalities

1. Government Solutions

Subsidies

Subsidies are a form of support given to producers that help reduce the cost of production which results in an increase in production and consumption. Goods that governments want to increase the consumption of are subsidized. Subsidies should be provided for goods with positive externalities.

Indirect Taxes

An indirect tax is a tax applied to the manufacture or sale of goods and services. Indirect taxes discourage consumption of goods and services and is represented by a decrease in supply. The government should impose Indirect Taxes on products with negative externalities.

Education and regulation are also ways of controlling the quantity consumed and produced.

B. Private Solutions

Moral codes

Moral codes guide individuals’ behavior. For example: littering. The likelihood of being fined may be small, but moral codes provide an incentive to refrain from littering.

Charities

Charities channel donations from private individuals towards fighting to limit behaviors or promoting behaviors. For example: Donations to help protect the environment.

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