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Tutor2u - Externalities from Production and Consumption


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Externalities seem to be everywhere! Little wonder that you probably won’t get through a micro exam paper without bringing externalities into your analysis and evaluative discussion! There is a lot to cover so start your revision early on this topic! You will need to be able to illustrate external costs and external benefits using marginal analysis, and then distinguish between the market and social optimum positions. Showing the welfare loss or gain areas are required as you analyse the effects of externalities from both production and consumption. One key evaluation point to remember – not all externalities are that important – but many are which is why this is a favoured topic for examiners.

Published in: Economy & Finance
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Tutor2u - Externalities from Production and Consumption

  1. 1. Externalities from Production and Consumption
  2. 2. Market Failure Externalities from Production and Consumption
  3. 3. Externalities and Market Failure • Externalities are spill-over effects arising from production and consumption for which no appropriate compensation is paid • Externalities lie outside the market transaction / price • Externalities cause market failure if the price mechanism does not take account of the social costs and benefits of production and consumption • Externalities can be positive and/or negative Externalities are a major cause of market failure and occur in nearly every market – be clear on effects for producers and consumers Negative Production Externalities Negative Consumption Externalities Positive Production Externalities Positive Consumption Externalities
  4. 4. Private and External Costs and Benefits • Private costs are the costs faced by the producer or consumer directly involved in a transaction • Private benefits are the benefits for producer and/or consumer directly involved in an economic transaction • The existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption • Social Cost = Private Cost + External Cost • Social Benefit = Private Benefit + External Benefit • When negative externalities exist, social costs exceed private cost. This leads to over-production and market failure if producers do not take into account the externalities • When positive externalities occur, social benefits exceed private benefit – this can also lead to market failure
  5. 5. Summary of Private and Social Costs and Benefits • Cost to the producing firm of producing an additional unit of output Marginal private cost (MPC) • Cost to third parties from the production of an additional unit of output Marginal external cost (MEC) • Total cost to society of producing an extra unit of output. MSC = MPC + MEC Marginal social cost (MSC) • Benefit to the consumer of consuming an additional unit of output Marginal private benefit (MPB) • Benefit to third parties from the consumption of extra unit of output Marginal external benefit (MEB) • Total benefit to society from consuming an extra unit, MSB = MPB + MEB Marginal social benefit (MSB)
  6. 6. Calculating Social Costs & Social Benefits – An Example New city motorway New schools Airport extension New hospitals Private benefits 50 135 130 80 Private costs 120 80 100 65 Positive externalities 90 55 35 120 Negative externalities 60 20 60 45 Net private benefit -70 +55 +30 +15 Net social benefit -40 +80 +5 +90 A government is considering four investment projects. It has the resources to finance and implement only one of these projects. Net social benefit may be taken into account by a government when deciding which project offers the best potential return for society
  7. 7. How do economists value externalities? A key aspect of all externalities is the difficulty of assigning values • Shadow pricing: e.g. the external cost of road congestion can be calculated by multiplying the number of hours lost by the average wage e.g. 1m lost working hours x £12 average hourly wage = £12m • Compensation: estimate the cost of ‘putting right’ an externality e.g. include the cost of installing double glazing in houses affected by increased road noise from a new motorway. If 200 houses are affected each with £5,000 double glazing cost, increased road noise is estimated at £1m • Revealed preference: how much people are willing to pay to avoid an externality e.g. if 200 householders are willing to pay £2,000 each to avoid noise, the externality is valued at £0.4m
  8. 8. The Importance of Property Rights • Property rights confer legal control or ownership of scarce resources • For markets to operate efficiently, property rights must be protected • Put another way, if an asset is un- owned, no one has an incentive to protect it from abuse / over-use. • Failure to protect property rights may lead to the Tragedy of the Commons • Examples include the over use of common land and the long-term decline of fish stocks caused by over-fishing which leads to permanent damage to the stock of natural resources Fish farms have expanded in recent years Common land is open for usage without restriction
  9. 9. Get help from fellow students, teachers and tutor2u on Twitter: @tutor2u_econ
  10. 10. Tutor2u Keep up-to-date with economics, resources, quizzes and worksheets for your economics course.