Externalities

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    Externalities

    Calculations

     

    Social Costs = Private  + External Costs

    Social Benefits = Private + External Benefits

    Definition

    • Social costs and benefits are therefore the costs and benefits incurred by the entirety of society (producer, consumer and third party) as a result of the production and/or consumption of a good or service.
    • Private costs and benefits are the costs and benefits incurred by individuals directly involved in the production and/or consumption of a good or service.

     

    • Where no market failure exists social costs would be equal to private costs.
    • If external benefits exist more of the said good should be produced and consumed (it is being under-consumed or under-produced) thus the market system is not supplying the optimum resource allocation.
    • If external costs exist than less of the said good should be produced and consumed (it is being consumed or produced in excessive quantities) thus the market system is not supplying the optimum resource allocation.
    • Firms and individuals will not consume/produce any good or service unless the private benefit of their activity exceeds the private cost incurred in their activity.

    The government will make sure that:

    • Merit goods (goods with external benefits) are encouraged (to prevent under-consumption or under-production from occurring.)
    • Demerit goods (goods with external costs) are discouraged (to prevent over-consumption or over-production from occurring.)
    • Demerit goods do not have prices which account for their external costs.
    • Smoking and alcohol are examples of demerit goods.

    The government will:

    • Subsidize merit good producers to reduce the costs of production and thereby encourage production of such goods whilst causing prices to be lowered as a result of the increase in supply and the decrease in prices of production caused by subsidization.
    • Tax demerit good producers to increase the costs of production and thereby discourage production of such goods whilst causing prices to increase as a result of the decrease in supply caused by taxations as well as by the increase in the price of production.
    • Sometimes the government may choose to nationalize certain industries that are producing externalities to regulate and control them and so force them to produce at the socially optimum level.
    • Laws and regulations –Limits on the level of emissions of certain chemicals through use of the law and a fining system to punish firms for infringement.
    • Ban on the use of certain chemicals which may result in significant external costs through use of the law and a fining system to punish any infringement.
    • Forcing firms to internalize all costs: Pollution permits (these can be traded to firms who can then pollute more at a reasonable price). Pollution permits are given out to firms by the government before any trading is done. (Equivalent and derived from the Carbon Credits used internationally to restrict national pollution). But this scheme is costly (administration costs are high) to implement, it is difficult to measure pollution levels accurately, rich firms may simply buy their permits off poorer firms and so pollution may not have been decreased at all, it is hard to calculate how many pollution permits to give out.
    • If external benefits exist then the public would be willing to pay more for a certain good to assure that it is produced at the socially optimum level. (Increase in demand, extension along the supply curve).
    • If external costs exist that the public would be willing to pay more to assure that it is produced at the socially optimum level. (Decrease in supply, contraction along the demand curve.)

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