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The concept of external costs and benefits.

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Katarina Kollarova Class 12 Economics: Explain using examples, the concept of external costs and benefits. Why are these market failures? What can governments and society do to correct these externalities? A market represents the private forces of demand and supply. Consumers demand products to maximise their own welfare and producers supply them to maximise their own profit. However, there are cases where markets clearly do not work well, or do not work at all. These cases are known as market failures. There are many market activities that affect other people. These are known as externalities. They are the positive and/ or negative effects that exchanges between producers and consumers may have on people who are not in the market. When such effects are pleasurable they are called external benefits. When they are unpleasant, or impose a cost on people other than the buyers or sellers, they are called external costs. Externalities occur when one person's actions affect another person's well being and the extra costs and benefits are not reflected in the price. A positive externality is for example when my neighbours benefit from my cleaning up my garden. A negative externality arises when one person's actions harm another. ...read more.


Some producers may not care whether they cause harm to others by polluting the environment. Even environmentally concerned producers cannot afford to care too much about the environment. While most people are unaware of it, markets often solve public goods and externalities problems in a variety of ways. Businesses frequently solve free-rider problems by developing means of excluding nonpayers from enjoying the benefits of a good or service. You can only watch cable television, if you've paid for the service. Private roads charge the people that use them. To see the effects of external benefits, consider the market for flu shots. The cost of producing vaccine includes labor, research and production equipment, materials, and transportation. Individuals receive important personal benefits from flu shots. The fact that many millions of people pay for them every year shows that there is a demand. In getting shots for themselves, however, people also provide external benefits for others. By protecting themselves, they reduce the probability that the flu will spread to others. Because a free market can fail to capture such external benefits, government action to subsidize flu shots may be imposed. It can also be extended to services such as public transportation. ...read more.


Property rights are a less effective solution for environmental problems involving the air, however, because rights to the air cannot be defined and enforced easily as air is a free good as it isn't scarce. A more practical solution is to increase private ownership in the system of property rights. Many people argue that externalities exist when property rights are incomplete. Reducing the role of private property would make the externality problem worse. When no one owns the air or water, there is no incentive to avoid an overuse of the resource. Private-property rights force people to take into account all costs and benefits of their actions. When a resource is owned by all, when it is free, there is a strong tendency for individuals to misuse that resource. The existence of private property rights allows the law to deal with externality problems. Finally, there may not be a good solution to the problem of "free" resources for two reasons. First, the cost of a solution may be greater than the benefits of the solution. Second, there may be externality problems within the government just as there can be externality problems in the market. When there are externality problems in the market, we can call on the government as an outside agent to solve them. But if these problems exist in the government, there is no one to turn to. ...read more.

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