Negative Externalities (DP IB Economics)

Revision Note

Last updated

Negative Externalities of Production

  • Negative externalities of production are often created during the production of a good/service

  • The market is failing due to over-provision of these goods/services as only the private costs are considered by the producers and not the external costs

    • If the external costs were considered, the supply would decrease and they would be sold at a higher price

    • Common examples include air pollution, water contamination, health problems in local communities
       

2-8-2-negative-externalities-of-production

External costs of production (negative externality) result in an over-provision shown by the gap between Qopt and Qe

 

Diagram Analysis

  • The marginal social benefit (MSB) is assumed to be equal to the marginal private benefit (MPB) as the focus is on the producer side of the market

  • The free-market equilibrium can be seen at PeQe. This is where the MPC = MSB

  • The larger the external costs in production, the larger the gap between the MPC and the marginal social cost (MSC)

  • The optimum allocation of resources from society’s point of view, would generate an equilibrium where MSB = MSC

    • This can be found at PoptQopt

    • There is no market failure at this equilibrium

  • The free market is failing due to over-provision of this good/service equal to Qe-Qopt

  • The factors of production used to manufacture this over-provision represent a welfare loss to society (pink triangle)

  • To be socially efficient, fewer factors of production should be allocated to producing this good/service

  • There is an opportunity for government intervention (indirect taxes, legislation, regulation etc.), to force this market to be more socially efficient

  • Any intervention that reduces the welfare loss will be beneficial

Negative Externalities of Consumption

  • Negative externalities of consumption are often created during the consumption of a good/service e.g. the waste generated outside fast food outlets often has to be cleaned up and paid for using taxpayers' funds

  • The market is failing due to over-consumption of these goods/services as only the private costs are considered by the consumers and not the external costs

    • If the external costs were considered, demand would decrease and they would be sold at a lower price

    • Common examples include cigarettes, alcohol, fatty foods, single-use plastic products etc.
        

2-8-2-negative-externalities-of-consumption

External costs of consumption (negative externality) result in an over-consumption shown by the gap between Qopt and Qe

 

Diagram Analysis

  • The marginal social cost (MSC) is assumed to be equal to the marginal private cost (MPC) as the focus is on the consumer side of the market

  • The free-market equilibrium can be seen at PeQe. This is where the MPB = MSC

  • The larger the external costs in consumption, the larger the gap between the MPB and the marginal social benefit (MSB)

  • The optimum allocation of resources from society’s point of view, would generate an equilibrium where MSB = MSC

    • This can be found at PoptQopt

    • There is no market failure at this equilibrium

  • The free market is failing due to over-consumption of this good/service equal to Qe-Qopt

  • The factors of production used to manufacture this over-consumption represent a welfare loss to society (pink triangle)

  • To be socially efficient, fewer factors of production should be allocated to producing this good/service

  • There is an opportunity for government intervention (indirect taxes, legislation, regulation etc.), to force this market to be more socially efficient

  • Any intervention that reduces the welfare loss will be beneficial

Worked Example

Using information from the diagram below, calculate the welfare loss that is caused by the negative externality of production [2]

A demand and supply diagram from which calculations are performed to determine the size of the negative externality of production

Answer:

Step 1: Identify the area of welfare loss

  • This product is over produced - there should be less of it

  • Welfare loss to society is the triangle formed by the arrowhead which points back towards the socially optimal quantity (70,000)
     

Step 2: Calculate the area of the triangle

Welfare space loss space equals space fraction numerator straight b space straight x space straight h over denominator 2 end fraction

Welfare space loss space equals space fraction numerator open parentheses 100 comma 000 space minus space 70 comma 000 close parentheses space straight x space open parentheses £ 80 space minus space £ 40 close parentheses over denominator 2 end fraction space bold space

Welfare space loss space equals space fraction numerator 30 comma 000 space straight x space 40 over denominator 2 end fraction

Welfare space loss space equals space fraction numerator 30 comma 000 space straight x space 40 over denominator 2 end fraction
space

Welfare space loss space equals space £ 600 comma 000 space space bold space

(2 marks)

Demerit Goods

  • Demerit goods are goods which have external costs in consumption

    • These goods are usually addictive and harmful for consumers e.g. gambling, alcohol, drugs, sugary foods/drinks

    • Governments often have to regulate these goods in such a way that they raise the prices and/or limit the quantity demanded 
       

  •  The activities of producers can generate significant external costs e.g. pollution caused by coal-burning power stations during the production of electricity

    • However, electricity is considered to be a merit good

    • The smoke is a by-product and not a good/service
       

  • For this reason, economists usually consider demerit goods to be goods used in consumption

You've read 0 of your 10 free revision notes

Unlock more, it's free!

Join the 100,000+ Students that ❤️ Save My Exams

the (exam) results speak for themselves:

Did this page help you?