1. Externalities
AS Economics- Lesson 2

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.

3. 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.

4. 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.

5. 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

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. Internalising the externality through indirect taxation
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

13. 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.

14. 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.

15. 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.

16. 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).

17. 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.

18. 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)