The concept of external costs and benefits.

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Katarina Kollarova

Class 12


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. For example polluting, factory owners may not consider the costs that pollution imposes on others.

Public goods have such massive positive externalities compared to small private benefits that they would barely be produced at all in a purely market economy.

Public goods have two distinct aspects – "non-excludability" and "non-rivalrous consumption." Non- excludability means that nonpayers cannot be excluded from the benefits of the good or service. If someone wants to stage a fireworks show, people can watch the show from their windows or gardens. Because the person cannot charge a fee for watching the fireworks, the fireworks show may go unproduced, even if demand for the show is strong.

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This fireworks example shows the "free-rider" problem [the tendency for the scale of provision of a public good to be too small – to be allocatively inefficient if privately provided]. Even if the fireworks show is worth ten dollars per person, no one will pay ten dollars to the person staging the show. Each person will seek to "free-ride" [someone who consumes a good or service without paying for it] by allowing others to pay for the show, and then watch for free from his or her window. If the free-rider problem cannot be solved, valuable goods and services will ...

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