Negative Externalities (DP IB Economics)
Revision Note
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
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.
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]
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
(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
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