Discussion #2 Externalities come about when individuals impose costs on or provi

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Discussion #2

Externalities come about when individuals impose costs on or provide benefits to others but do not consider those costs and benefits when deciding how much to consume or produce. Thus externality is a cost or benefit received by a person not involved in a market transaction, and therefore not reflected in the market price of the commodity being transacted. There are two types of externalities: positive externalities and negative externalities.

A positive externality exists when an individual or firm making an economic decision does not receive the full benefit of the decision. In this case, the social benefit is greater than the benefit that goes to the individual or firm.

A negative externality occurs when an individual or firm making a decision does not have to pay the full cost of the decision. If a good has a negative externality, then the cost to society is greater than the cost consumer is paying for it.

Both positive and negative externalities result in market inefficiencies unless proper action is taken.

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Explanation / Answer

A positive externality arises when the private costs are greater than social costs, and the benefits of a good is not only borne by the person who consumes it but also by some people who don't consume it. Consider for example of flu shots. The person who purchases flu shots is less like to get sick. However, the society also benefits as there is less chances of others contracting the flu virus from this person. Hence, the people who are in contact with this person and who have not taken flu shot have also benefitted as they are now less like to contract the virus.
A negative externality arises when the private costs are smaller than social costs, and the costs occur not only to the person consuming it but also by some people who are not purchasing the good. Consider the example of gasoline. When a person purchases gasoline, he pays for it. But gasoline consumption creates pollution and other people who are not consuming gasoline are worse off due to increased pollution.

• Why do positive and negative externalities lead to inefficiency in the market economy?

Under positive externalities, there is no incentive for people to spend money on these goods as they want to derive the benefit through someone else's consumption. As such, the consumption/production of such goods is less than efficient level. Under positive externalities, there is no incentive for people to spend money on these goods as they want to derive the benefit through someone else's consumption. As such, the consumption/production of such goods is less than efficient level.
Under negative externalities, the people who purchase the good only bear a part of the cost. As such, people consume more than what they would have consumed if they were paying the full cost. The consumption/production of such goods is more than efficient level.

• How can externalities be addressed using the private sector to reduce market distortions of externalities?

In the case of positive externalities, subsidizing consumption would lead to private costs being equal to social costs and hence eliminating distortions. The negative externalities could be solved by taxing consumption. In the case of positive externalities, subsidizing consumption would lead to private costs being equal to social costs and hence eliminating distortions. The negative externalities could be solved by taxing consumption.

• What government policies help deal with positive and negative externalities by reducing inefficiency?

Positive Externality: Positive Externality: 1. Subsidies made to producer or consumer 2. Legislation ex: mandatory seatbelt use, mandatory flu shots etc (fixes consumption by law at the efficient level)
Negative Externality 1. Imposition of taxes, either on producer or the consumer 2. Regulation like pollution permits etc. (fixes consumption by law at the efficient level)

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