Chapter 16, Problem aWYWL

To determine

Externality, inefficiency and government intervention.

Concept Introduction:

Externality in Economics:

In economics, externality is a concept which discusses the consequence of an economic activity which can have a positive or a negative impact on the third party who is completely unrelated to the activity.

Positive externality:

Externality which creates benefit to the third party is positive externality.

Negative externality:

Externality which creates harm to the third party is negative externality.

Marginal Social benefit:

The marginal social benefit is the change in total benefit to the society from the consumption of one extra unit of a good or service.

Marginal Social cost:

The marginal social cost is the change in total cost incurred by the society for the consumption of one extra unit of a good or service.

Marginal individual benefit:

The marginal individual benefit is the change in total benefit to an individual from the consumption of one extra unit of a good or service.

Marginal individual cost:

The marginal individual cost is the change in total cost incurred by an individual for the consumption of one extra unit of a good or service.

Socially optimal level of output:

The level of output at which marginal social benefit is exactly equal to marginal social cost is known as socially optimal level of output. If output is at some other point, market failure exists. It is also known as the allocative efficient level of output.

Explanation of Solution

Externality and inefficiency:

Market equilibrium corresponds to the perfect equilibrium between benefits that the consumers receive and the costs that the producers incur. This situation result in the optimal level of production. Externality on the other hand, is the consequences of an economic activity, which may create an imbalance between the true costs and benefits of the product or service. This equilibrium will not reflect the accurate level of optimum in the case of that product or service. This situation will lead to make one group better off than the other. This market failure leads to inefficiency.

In case of negative externality, the total cost of production includes the social cost is not completely borne by the producers. As the cost is shared, it results in excess production.

In case of positive externality, the consumer does not get all the benefits, the third party also gets a share of it as social benefit. It results in decreased production.

Activities where social benefit exceed private benefit are often inadequately provided by a market system.

Government intervention:

Government intervention is required to reduce the inefficiencies and overcome market failures.

The government policy should provide subsidies to the market with positive externalities to increase production.

On the other hand, Government needs to penalise the organizations creating negative externalities by imposing high taxes on them and increasing their production cost and as a result reducing the quantity of production.

Regulation is a method which is widely used in the UK and throughout the world to control externalities.

A variation on regulating negative externalities through direct controls is the idea of issuing permits.