Explain and illustrate the concept of externalities.

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Introduction

Q. Explain and illustrate the concept of externalities EXTERNALITIES 'An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect' .In the presence of externalities it is not only the well being of buyers and sellers, but also the well-being of bystanders which affect the market outcome.' There are 4 types of externalities - positive production externality, negative production externality, positive consumption externality and negative consumption externality. I will try to explain all of them in more detail below. Negative Production Externality. Firms that are involved in making for example paper are also involved in making a chemical called dioxin (not because they want to, but because its impossible to make paper without producing this chemical). And it has been proven by scientists that once dioxin enters the environment it increases the chance of people getting cancer, birth defects and other health problems. But there is nothing a firm can do to prevent the exhaust of those poisonous gases, because the opportunity cost is great thus

Middle

Because of the externality the cost of producing paper to society is greater than the cost to producers of paper, we will need to add the cost of bystanders affected by the dioxin to the cost of producing paper itself. The social-cost curve is higher than supply curve because it takes into account the cost of negative externalities that are included in production of paper. The firm will then choose to produce paper at the level when the social-cost curve crosses the demand curve , this intersection will determine the optimal amount of paper to produce from the standpoint of the society as a whole. The best way to achieve this would be for government to tax the production of paper, the tax would shift the supply curve of paper upward by the size of the tax, and if the tax properly calculated the social cost of smoke released by the paper factory, the supply curve will coincide with the social-cost curve, and paper producers will produce the socially optimum amount of paper.

Conclusion

The analysis of n consumption externalities is very similar to those in production. On drawing (a) the social cost of producing alcohol is less than its private cost and the socially optimal quantity is smaller than the quantity determined by the private market. On drawing (b) the social value is greater than the private value and the socially optimal quantity is greater than the quantity determined by the private market. So once again we need the government to control the market. To move the market equilibrium closer to the social optimum a negative externality requires a tax, and a positive externality requires a subsidy. 'Negative externalities in production or consumption lead markets to produce a larger quantity than Is socially desirable. Positive externalities in production or consumption lead markets to produce a smaller quantity than is socially desirable. To remedy the problem, the government can internalize the externality by taxing goods that have negative externalities and subsidize the goods that have positive externalities.' Although externalities lead to market inefficiency it is not always necessary for government to solve the problem, in some circumstances people can develop their own solutions. Sergey Zubakin

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