10 Questions
What is the main characteristic of good Z that distinguishes it from good X?
It affects the utility of other people
What is the relationship between the level of cigarettes consumed by other individuals and the individual's utility?
It has a negative effect on the individual's utility
What is the optimal level of good Z in the presence of an externality?
Where private marginal benefit equals social marginal benefit
What is the graphical representation of the externality?
The difference between the social marginal benefit and private marginal benefit curves
What is the relationship between public goods and externalities?
Public goods are an example of positive externalities
What is the role of the Samuelson rule in this context?
It relates to the externality and public goods
What is the effect of the externality on the individual's utility?
It decreases the individual's utility
What is the main difference between private marginal benefit and social marginal benefit?
Private marginal benefit reflects the individual's utility, while social marginal benefit reflects the utility of all individuals
What is the implication of the externality on the market outcome?
The market will underproduce good Z
What is the role of the government in correcting the externality?
The government should impose a tax on good Z
Study Notes
Externalities Overview
- An externality occurs when one economic agent's welfare (utility or profit) is directly affected by the action of another agent (consumer or producer) in the economy.
- Externalities arise when the effect of one agent's action on another agent is not mediated by prices.
Definitions
- Most general definition: 𝑼𝒕𝒊𝒍𝒊𝒕𝒚 𝑷𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒐𝒏 𝑼𝒉 = 𝑈 !(𝑥, 𝑦)
- Consumption level must be chosen by both individual and collective decisions, which affect their utility.
Classification
- Externalities can be classified by direction of the effect:
- Positive externality (positive effect) à “external benefits”
- Negative externality (negative effect) à “external costs”
- Externalities can also be classified by agent affected:
- Consumption externalities (consumers are affected)
- Production externalities (producers are affected)
Examples
- Fishery's productivity is affected by river pollution caused by an oil refinery upstream
- Factory that produces pollution close to a field, affecting farmers
- Pearson smoking next to me – negative externality
- Research and development – positive externality
- Farmers affected by pollution
Market Inefficiency
- Market inefficiency arises due to externalities, as the optimal level of consumption or production is not achieved
- Utility of one agent depends on the consumption and production decisions of other agents
- Private marginal benefits (PMB) and private marginal costs (PMC) do not reflect the social marginal benefits (SMB) and social marginal costs (SMC)
Graphical Representation
- Social marginal benefits (SMB) curve is different from private marginal benefits (PMB) curve
- The difference between SMB and PMB curves represents the external benefits (or costs)
- SMB curve is on the right if externality is positive, and on the left if it is negative
Test your understanding of externalities, including definitions, classifications, and examples. Learn how externalities can lead to market failures and inefficiencies, and explore possible solutions. This quiz covers the basics of externalities and their impact on the economy.
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