Transcript File

Externalities
AS Economics- Lesson 2
Lesson Objectives
• To be able to define externalities.
• To understand the difference between private and social costs.
• To analyse why the greater the externality, the greater the likelihood
of market failure.
New Key Terms
Private Costs- These are costs of an activity to an individual or firm. For
example you will need to pay the price for an if you want to consume it, or a
firm will need to pay for labour if it wants staff to work.
Social Costs- These are the costs that society bear as a consequence of an
activity. For example the NHS has costs that arise from acid erosion you get
on your teeth from the apple you ate.
Private Benefits- This is the benefits an individual receives from an activity.
For example the energy and taste of the apple.
Social Benefits- These are the benefits society receives as a consequence of
an activity. For example the beautiful apple blossom on the tree which
produces the apple.
Externality
Economic activity takes place when a good or service is produced, provided and
consumed. A market is any mechanism which allows a buyer and seller to agree
on a price for the good and service and allow exchange to take place.
However, the activities of buyers (or consumers) and sellers (or
suppliers/producers) may have wider effects on the community and environment.
These spill over effects, or external costs or benefits, are known as externalities.
In considering the impact of economic activity on social welfare, it is important to
examine both the private costs and benefits (those affecting consumers and
producers) and the external costs and benefits (those affecting third partiess.
An externality occurs when there is a difference between private and social costs
and benefits. We are said to have a negative externality if the social cost is higher
than the private cost and a positive externality if the social benefit is higher than
the private benefit.
Externalities
Social Benefits = Private Benefits + External Benefits
Social Costs = Private Costs + External Costs
Net Social Benefits (or overall impact on social welfare) = Social Benefits –
Social Costs
Negative Externalities
Examples of negative externalities include pollution resulting from industry or
car use. Pollution can harm the economic welfare by eroding the quality
and cleanliness of air and water, creating noise, or degrading the aesthetic
environment.
Negative externalities can also exist on a more localised scale, for example
anti-social behaviour in the street late at night or passive smoking. Both
consumption and production externalities are possible. The motor car
industry, for example, may lead to both, with car manufacturers emitting
pollution from their factories and drivers creating pollution and
congestion when they use the finished good.
If the good (e.g. Car use) is left to market forces (free market) it is likely that welfare
will be reduced due to the failure of market forces to account for the impact of its
consumption. This can be seen in the figure below.
Demand can also be referred to as
marginal private benefit (MPB).
Consumers buy the goods and
services which maximises their
utility, or satisfaction, and this has a
positive impact on social welfare.
Producers base their decision on the
private costs of production: the
payments necessary for the factors
of production required to supply the
good. The marginal private cost
curve is effectively the supply curve
for the good i.e. The price required
to produce one more unit of output.
Negative Externalities
However, where negative
externalities exist, the marginal
social cost (MSC) of supply is
greater than the marginal private
cost (MPC). Thus at the free market
equilibrium of pm and qm, the
external costs can be shown as the
area ABC. This represents the range
of output where social costs exceed
the private benefits. Thus a good
with negative externalities will tend
to be overproduced and
overconsumed in a free market.
Policies to tackle negative externalities
Governments may choose to intervene to correct market failure with the aim
of achieving the socially optimal allocation of resources.
Bans- Goods which create negative externalities in either consumption or
production are seen as “bad” for society unless the level of output is
moved to the socially optimal level. One possible policy is to ban the good
altogether. However, as tempting as it may be to assume that shifting
production and consumption to zero will maximise social welfare, in
reality this is rarely the case.
Impact of a ban on social welfare
This figure shows the impact
on welfare of banning a good
such as cigarettes or unleaded
petrol. The free market level of
output is qm which creates
external costs equivalent to the
area surrounded by the
boundary points ABC.
However, banning the good
altogether removes a range of
output where private benefit
actually exceed social costs
i.e. 0 to qs. Thus the ban
actually removes the net social
benefit marked as the region
CEF.
Is a ban ever justified?
YES! This figure shows a market for a good where the socially optimal level
of output is zero: there is no output level where private benefits exceed
social costs and in this case the ban is justified.
Taxes
Taxing goods which create negative externalities is very common and such taxes are called,
variously, green taxes, sin taxes and pigou taxes (after the English economist Arthur Pigou).
It is shown in the previous figure that an outright ban may actually harm social welfare even
when negative externalities exist. The imposition of an indirect tax on the supply of a good
shifts the supply curve (or social cost curve) to the left, limiting output and pushing up price.
Thus, if a tax is set at a level equal to the external cost per unit, the supply curve becomes
the marginal private cost curve. Thus the market equilibrium after the tax becomes socially
optimal output.
Internalising the externality through indirect
taxation
Subsidising alternatives- taxing a “bad” will reduce quantity demanded to
some extent, depending on the price of elasticity of demand of the good.
An alternative is to reduce demand of the “bad” by subsidising
alternatives, for example bio fuels research and production to reduce the
demand for petrol, or subsidising nicotine substitutes to help smokers quit
cigarettes.
Compulsory Consumption
A more drastic approach may be to make a certain alternative compulsary,
such as enforced recycling to limit waste sent to landfill sites. In some
areas of the UK this has been controversial as large firms have been
imposed on households committing apparently minor errors of refuse
sorting! As with any such policy, monitoring and legal enforcement may be
necessary- and also expensive.
Regulation
The production and consumption of goods which incur external costs on
society are often regulated by government legislation. For example alcohol
and cigarettes are regulated by age limits and can only be sold in certain
outlets and (in case of alcohol) at certain times.
Extending Property Rights
Property rights are the entitlement of an individual to legal ownership. By
extending property rights to, for example clean air and peace and quiet,
polluters can be made liable for the external costs they create. For
example, if a smoker at a bus stop was forced to pay compensation to
anyone breathing in their smoke both the quantity of cigarettes consumed
would be lower and third parties would be compensated for the
discomfort (providing property rights can be fully enforced).
Cap and Trade/ Pollution Permit Trading
Global warming is seen by many as one of the most pressing problems to face the world. One
solution to limiting carbon dioxide emissions (on a local, national or even global scale) is to
use a scheme of permit trading, also known as cap and trade. This sets a quota (a maximum
level) on polluting activities such as air travel or heavy industry.
Such as scheme involves a maximum limit being placed on emissions. Permits are then
distributed between all polluters, with permission granted to trade permits as desired. In
theory, such a scheme provides an incentive to reduce emissions (and develop cleaner
technologies) without limiting output (and therefore economic growth and development) in
industries and economies which are unable to afford clean technologies. The free market for
permits, would in theory, require minimal monitoring: low polluting industries would sell
unused permits to high polluting industries and in the long-run, the total level of emissions
could be reduced as claner energy sources are developed. A permit scheme- in which,
effectively, a market for pollution is established- requires agreement on the maximum level
and enforcement to ensure all emissions are included within the system.
Personal Carbon Allowances
The UK government was reported to be considering a personal allowance
scheme in 2008 in which individuals were allocated a maximum level of
emissions with any surplus being tradeable. This would benefit “green”
individuals and also allow the production and consumption of polluting
goods to continue for those households willing to pay for extra permits.
As with cap and trade schemes on a wider scale, such a policy could be used
over time to bring down the total emissions level (and push up the prices
of permits- the cost of polluting-in the process)