Externalities

Yassmin Dehesh
Mind Map by Yassmin Dehesh, updated more than 1 year ago
Yassmin Dehesh
Created by Yassmin Dehesh about 6 years ago
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A mind map on Externalities from Chapter 5: Market Failure

Resource summary

Externalities
  1. Production Externalities
    1. Positive Externalities of Production
      1. external benefits created by producers. If, for example, a firm engages in research and development, and succeeds in developing a new technology that spreads throughout the economy, society benefits from widespread adoption of the new technology. Therefore, the social costs of research and development are lower than the private costs.
        1. Welfare Loss
          1. The underallocation of resources to the production of a good with a positive production externality leads to a welfare loss. It involves external benefits for society that are lost because not enough of the good is produced. If the externality were corrected, society would gain the benefits represented by the shaded area.
          2. Correcting positive production externalities
            1. Direct government provision
              1. A solution often pursued by governments involves direct government production of the good or service creating the positive production externality. governments often engage in research and development. The government can also directly provide training for workers. This shifts the supply curve to the right, (increasing it) and drops the price to optimum.
              2. Subsidies
                1. If the government provides a subsidy to a firm per unit of the good produced that is equal to the external benefit, then the marginal private cost (MPC = supply) curve shifts downward (or rightward) until it coincides with the MSC curve. The result is to increase quantity produced to Qopt and to lower the price from Pm to Popt.
          3. Negative Externalities of Production
            1. external costs created by producers. The problem of environmental pollution, created as a side-effect of production activities, is very commonly analysed as a negative production externality.
              1. Welfare loss
                1. a loss of social benefits due to overproduction of the good caused by the externality. If the externality were corrected, so that the economy reaches the social optimum, the loss of benefits would disappear. he shaded area represents the welfare loss arising from the negative production externality. Society would be better off if less were produced.
                2. Correcting negative production externalities
                  1. Government regulations
                    1. Government regulations to deal with negative production externalities rely on the ‘command’ approach, where the government uses its authority to enact legislation and regulations in the public’s interest. More commonly, regulations do not totally ban the production of pollutants, but rather attempt to achieve one of the following: • limit the emission of pollutants by setting a maximum level of pollutants permitted • limit the quantity of output produced by the polluting firm • require polluting firms to install technologies reducing the emissions.
                    2. Market-based policies
                      1. Imposing a tax
                        1. The government could impose a tax on the firm per unit of output produced, or a tax per unit of pollutants emitted. The optimal (or best) tax policy is to impose a tax that is exactly equal to the external cost, so the MPC curve shifts upward until it overlaps with MSC. The new equilibrium results in the lower, optimal quantity of the good produced, Qopt, and higher, optimal price, Popt.
                        2. a tax on pollutants (emissions)
                          1. A tax on emissions (carbon tax) is set on specific company and encourages the use of green technology. The result is that if the firm switches to alternative, less polluting resources, Qopt will increase, because the external costs of producing the output will become smaller.
                          2. Tradable permits
                            1. These permits to pollute can be traded (bought and sold) in a market. If a firm needs to emit more pollutants than the level set by its permits, it can buy more permits in the market. As an economy grows and the firms increase their output levels, the demand for permits is likely to increase, as shown by the rightward shift of the demand curve from D1 to D2. With supply fixed, the price of permits increases from P1 to P2.
                  2. Consumption Externalities
                    1. Positive Externalities of Consumption
                      1. external benefits are created by consumers. For example, the consumption of education benefits the person who receives the education, but in addition gives rise to external benefits, involving social benefits from a more productive workforce, lower unemployment, higher rate of growth, more economic development, lower crime rate, and so on. Similarly, the consumption of health care services benefits not only the person receiving the services but also society and
the economy, because a healthier population is more productive, enjoys a higher standard of living and may have a higher rate of economic growth.
                        1. Welfare loss
                          1. represents the loss of social benefits due to underproduction of the good. If this externality were corrected, society would gain the benefits represented by the shaded area. the difference between the MSB and MSC curves for the amount of output that is underproduced relative to the social optimum (Q opt – Q m).
                          2. Correcting positive consumption externalities
                            1. Legislation
                              1. Legislation can be used to promote greater consumption of goods with positive externalities. For example, many countries have legislation that makes education compulsory up to a certain age. In this case, demand for education increases, and the demand curve D1 = MPB shifts to the right (or upward), as in Figure 5.14(a). Ideally, it will shift until it reaches the MSB curve, where D2 = MSB, and Qopt is produced and consumed.
                              2. Advertising
                                1. Governments can use advertising to try to persuade consumers to buy more goods with positive externalities. For example, they can try to encourage the use of sports facilities for improved health. The objective is to increase demand for such services, and the effect is the same as with legislation.
                                2. Direct government provision
                                  1. Governments are frequently involved in the direct provision of goods and services with positive consumption externalities. The most important examples include government (public) provision of education and health care in virtually all countries in the world. has the effect of increasing supply and therefore shifting the supply curve S rightward (or downward) to S + government provision. To achieve the social optimum Qopt, the new supply curve must intersect MPB at the level of output Q opt, as seen in the figure. At the new equilibrium, price falls to Pc
                                  2. Subisidies
                                    1. A subsidy to the producer of the good with the positive externality has the same effects as direct government provision. It results in increasing supply and shifting the supply curve rightward (or downward), as shown in Figure 5.14(c) (which is the same as Figure 5.14(b)). If the subsidy is equal to the external benefit, the new supply curve is MPC − subsidy, and it intersects MPB at the Popt level of output.
                                  3. The case of merit goods
                                    1. Merit goods are goods that are held to be desirable for consumers, but which are underprovided by the market. Reasons for underprovision include:
                                      1. positive externalities
                                        1. In this case too little is provided by the market. Examples of merit goods include education and immunization programes.
                                        2. Low levels of income and poverty.
                                          1. Some consumers may want certain goods or services but cannot afford to buy them.
                                          2. Consumer ignorance
                                            1. Consumers may be better off if they consume certain goods and services but they may be ignorant of the benefits, and so do not demand them.
                                    2. Negative Externalities of Consumption
                                      1. refer to external costs created by consumers. For example, when consumers smoke in public places, there are external costs that spill over onto society in the form of costs to non-smokers due to passive smoking. When there is a consumption externality, the marginal private benefit (demand) curve does not reflect social benefits.
                                        1. Welfare loss
                                          1. Negative externalities of consumption refer to external costs created by consumers. For example, when consumers smoke in public places, there are external costs that spill over onto society in the form of costs to non-smokers due to passive smoking. In general, negative externalities, whether these arise from production or consumption activities, lead to allocative inefficiency arising from an overallocation of resources to the good and to its over-provision.
                                          2. Correcting negative consumption externalities
                                            1. Government regulations
                                              1. Regulations can be used to prevent or limit consumer activities that impose costs on third parties, such as legal restrictions on activities as smoking in public places. This causes demand to fall until it eliminates the externality.
                                              2. Advertising
                                                1. Advertising and campaigns by the government can be used to try to persuade consumers to buy fewer goods with negative externalities, such as anti-smoking campaigns. The objective is to try to decrease demand
for such goods, and the effects are the same as with government regulations .
                                                2. Market-based policies
                                                  1. Market-based policies Market-based policies to correct negative consumption externalities involve the imposition of indirect (excise) taxes. Indirect taxes can be imposed on the good whose consumption creates external costs they raise the price so people use less.
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