4.1.8.4 Positive & negative externalities

• special type of “good” and “bad”.

• Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid.

• outside of the market ie. they affect people not directly involved in the production and/or consumption of a good or service.

• (No-one goes looking for noise, pollution, or even the positive externalities.)

• They are also known as spill-over effects.

• A person smoking a cigarette (or eating an egg sandwich) at a bus stop has made a deliberate economic decision to consume a product.

• The person standing next to her has not made that decision but is ‘consuming’ the bad smell resulting from the decision made by the other person.

• A family halfway down my street love their fireworks!

• They spend a huge amount on sophisticated fireworks on Guy Fawkes night and put on a great display.

• Assuming I enjoy fireworks, their economic decision to consume fireworks counts as a positive externality of consumption for me

Subjective

• Making furniture by cutting down rainforests in the Amazon displaces the indigenous people of the Amazon rainforest.

• It also leads to higher global warming as there are less trees to absorb carbon dioxide

• A farmer grows apple trees. An external benefit is that he provides nectar for a nearby beekeeper who gains increased honey because of the farmers orchard

• include both the private costs and any other external costs to society arising from the production of a good or service.

• Social cost = Private cost + External cost

• include the costs the firm pays to purchase capital equipment, hire labour, and buy materials or other inputs, for a producer of a good, service, or activity

• Private costs are paid by the firm and must be included in production decisions.

• not reflected on firms’ income statements.

• However, external costs remain costs to society, regardless of who pays for them.

product/project is good for society at large.

it will not be worthwhile for an entrepreneur/firm to invest.

• under-pricing

• over-consumption

• over-production of goods (Excess Supply)

• over-pricing

• under-consumption

• under-production (Excess Demand)

• market failure: the market mechanism producing the goods in the wrong quantities.

• costs resulting from the production process that aren’t paid for by the producer.

• costs of production

• Without having to pay for externalities, the supply curve is at S1. This is called the private supply curve. It leads to a private equilibrium at (Q1, P1).

• Supply curve S2 is the social supply curve. It factors in the external costs and leads to a social equilibrium at (Q2, P2). Notice that price is higher, and quantity is less

• vertical gap between the two supply curves represents the external costs.

• Without gaining the benefit of the externalities, the supply curve is at S1. This is called the private supply curve. It leads to a private equilibrium at (Q1, P1).

• A social equilibrium at (Q2, P2) including external benefits, could be achieved, for instance, by government subsidies to incentivise greater production

• This time the vertical gap between the two supply curves represents the external benefit. Positive Production Externalities P2 Q2

• producers may under-supply, knowing that they do not reap all the benefits of production

• The market (left to its own devices) fails, because the socially irresponsible private equilibrium will be the outcome.

• The government can intervene to ‘correct’ the market. It could, for instance, introduce a pollution tax, forcing companies to pay costs equal to the estimated* value of the negative externalities.

• This effectively shifts the supply curve back to S2 leading the market to find the social equilibrium.