Explain and illustrate the concept of externalities.

University Degree Business and Administrative studies

Sergey Zubakin

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 if they want to produce less dioxin they will have to produce less paper and thus getting less profit (which of course they will not do) considering it’s a profit-maximizing firm, and when firms fail to allocate resources efficiently, it is called a market failure. So it is up to the government to control the exhaust of dioxin, and thus prevent the market from allocating resources incorrectly, and protect the well-being of bystanders.

Without government intervention the demand curve for paper will reflect the value of paper to consumers, measured in amount of money they are willing to pay for it, and the supply curve will reflect the cost of producing paper, and the price will adjust to the balance of supply and demand for paper itself.

So the market allocates resources to maximize the total value to the consumers minus the total cost of production of paper.

But if we consider that the production of paper also includes the production of poisonous dioxin things will be different.

Because of the externality ...

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So the market allocates resources to maximize the total value to the consumers minus the total cost of production of paper.

But if we consider that the production of paper also includes the production of poisonous dioxin things will be different.

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.

Positive externalities in production

Those externalities opposite to negative externalities the bystanders actually benefit from the production. Lets take an example as a production of robots; whenever a firm builds a robot there is a chance that the firm will discover the new and better technology or design. The new technology will give benefit not only to the firm but to society as well.

In the case of positive externalities the social cost is less than the cost of producing robots, therefore the firm will want to produce more robots. In this case, to make the firm produce more robots the government should subsidize the production of robots, if the government would give firm money for every robot they produce the supply curve would shift downwards by the amount of the subsidy and it will increase the equilibrium quantity of robots.

CONSUMPTION EXTERNALITIES

The externalities should not be only associated with production. For example the consumption of alcohol gives negative externality because it is very likely that consumers will fall under its influence and can give risk to life of others. Similarly the

Consumption of education gives positive externality because a more educated population leads to a better society which benefits everyone. 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.