micro - externalities

Question 1

what is an externality?

Answer 1

a ‘spill-over effect’ whereby those not directly involved in the market transactions (third parties) are affected by the actions of others - not reflected in market prices.

Question 2

what are some examples of externalities?

Answer 2

pollution
residents along a flight path
residents and businesses in a rural village if a new bypass is built

Question 3

what is a private cost?

Answer 3

the cost of an activity incurred to an individual economic unit directly taking the particular action.

Question 4

what is an external cost?

Answer 4

the cost of an activity that is the consequence of externalities borne by third parties.

Question 5

what is a private benefit?

Answer 5

the benefits of an activity to an individual economic unit directly taking the particular action.

Question 6

what is an external benefit?

Answer 6

the benefits that accrue as a consequence of externalities to third parties.

Question 7

what is a social cost?

Answer 7

the total costs of a particular action

‘private costs’ + ‘external costs’

Question 8

what is a social benefit?

Answer 8

the total benefits of a particular action

‘private benefits’ + ‘external benefits’

Question 9

why are externalities an example of market failure?

Answer 9

the external costs/benefits distort the efficient allocation of resources. The market is producing/and or consumers are consuming either too little or too much of a good/service - market not allocatively efficient.

market price does not reflect the full cost/benefit of an activity - divergence between MSC and MSB.

Question 10

what does the demand curve represent?

Answer 10

the wants of consumers which ignore the effects that buying this product will have on outsiders - consumption

Question 11

what does the supply curve represent?

Answer 11

the costs of making the product for the producers, which ignore the effects that producing these products will have on outsiders - production

Question 12

what is a negative externality?

Answer 12

an economic action through consumption/production which has a negative spill over effect on third parties. - over-production is likely - MEC - costs

Question 13

what is a positive externality?

Answer 13

an economic action through consumption/production which has a positive spill over effect on third parties. - under-production is likely - MEB - benefits

Question 14

which way does the demand/supply curve move if it’s a negative externality?

Answer 14

to the left

Question 15

which way does the demand/supply curve move if it’s a positive externality?

Answer 15

to the right

Question 16

what is negative production externality?

Answer 16

1. the private costs (faced by the producer) are lower than the social costs (faced by society as a whole) - negative spill-over effects on third parties.
2. the producer will only take decisions based only on its private costs (MPC), ignoring the external costs it imposes on society, therefore over-production is likely.
   examples: pollution generated by a production process

Question 17

explain the negative production externality graph

Answer 17

in a free market, the market equilibrium price is at E1. This is not a good outcome for society because at Q1, there is a divergence between the market price (MPC) and the external MSC at E2. There is also a divergence between the MSC and the MSB, as the last unit sold imposes a higher cost to society than the benefits from producing it. This leads to an over-production of the good/service, thus not allocatively efficient - market failure. At Q1, the vertical distance between MPC and MSC, is the MEC imposed on society from this quantity, so E1, E2, and A represents welfare loss. Therefore, the optimum position for society is Q2, where P = MC - less good consumed and society would be better off.

Question 18

what is a positive production externality?

Answer 18

1. the private costs (faced by the producer) are higher than the social costs (faced by society as a whole) - positive spill-over effects on third parties.
2. the producer will only take decisions based only on its private costs (MPC), ignoring the external benefits it imposes on society, therefore underproduction is likely.
   examples: education, healthcare

Question 19

explain the positive production externality graph

Answer 19

in a free market, the market equilibrium price is at E1. This is not a good outcome for society because at Q1, there is a divergence between the market price (MPC) and the external MSC at E2. There is also a divergence between the MSC and the MSB, as the last unit sold imposes a higher cost to the producers than the benefits from producing it. This leads to an under-production of the good/service, thus not allocatively efficient - market failure. At Q1, the vertical distance between MPC and MSC, is the MEB imposed on society from this quantity, so E1, E2, and A represents welfare loss. Therefore, the optimum position for society is Q2, where P = MC - more good consumed and society would be better off.

Question 20

what is a negative consumption externality?

Answer 20

1. the private benefits (faced by the consumer) are higher than the social benefits (faced by society as a whole) - negative spill-over effects on third parties.
2. the consumer will only take decisions based on its private benefits, ignoring the external costs it imposes on society, therefore over-production is likely.
   examples: smoking, binge-drinking (costs NHS lots of money).

Question 21

explain the negative consumption externality graph?

Answer 21

in a free market, the market equilibrium price is at E1. This is not a good outcome for society because at Q1, there is a divergence between the market price (MPB) and the external MSB at E2. There is also a divergence between the MSC and the MSB, as the last unit sold imposes a higher cost to the society than the benefits from consuming it. This leads to an over-production of the good/service, thus not allocatively efficient - market failure. At Q1, the vertical distance between MPB and and MSB, is the MEC imposed on society from this quantity, so E1, E2, and A represents welfare loss. Therefore, the optimum position for society is Q2, where P = MC - less good consumed and society would be better off.

Question 22

what is a positive consumption externality?

Answer 22

the private benefits (faced by the consumer) are lower than the social benefits (faced by society as a whole) - positive spill-over effects on third parties.

2. the consumer will only take decisions based on its private benefits, ignoring the external benefits it imposes on society, therefore under-production is likely.
   examples: christmas lights, police force - a lot public goods.

Question 23

explain the positive consumption externality graph

Answer 23

in a free market, the market equilibrium price is at E1. This is not a good outcome for society because at Q1, there is a divergence between the market price (MPB) and the external MSB at E2. There is also a divergence between the MSC and the MSB, as the last unit sold imposes a higher cost to the consumer than the benefits from consuming it. This leads to an under-production of the good/service, thus not allocatively efficient - market failure. At Q1, the vertical distance between MPB and MSB, is the MEB imposed on society from this quantity, so E1, E2, and A represents welfare loss. Therefore, the optimum position for society is Q2, where P = MC - more good consumed and society would be better off.

Question 24

when is allocative efficiency achieved?

Answer 24

where P = MC