Explain Externalities and Public Gods

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With the aid of examples explain the terms:
i) Externality
ii) Public Good

Externality

Externalities, or transaction spillovers, arise when a third party who is not involved in the consumption of a product incur certain costs and benefits that are not compensated for by the generators of those externalities. They exist due to the price system’s (The Invisible Hand) inability to deal with products that have no market or price, such as clean air, peace, quiet, pollution and more. In a broader sense, externalities involve interdependence of utility due to the fact that one person’s action will affect the welfare of another.

Externalities can be classified into two types: positive externalities and negative externalities. Positive externalities exist when an externality-generating activity raises the production or utility of the third party receiving these externalities. These economic activities provide incidental benefits to others for whom they aren’t specifically intended. Negative externalities exist when an externality-generating activity decreases the production or utility of the third party receiving these externalities. These economic activities impose a cost onto others for whom they aren’t specifically intended.

The undesirable effects on the allocation of resources by an externality can be explained by using the concept of Marginal Social Cost (MSC). In Economics, the MSC is defined as the sum of Marginal Private Cost (MPC), the marginal cost caused by an activity that is compensated for by the generators, and Marginal External Cost, which is the share of external effects borne by the rest.

When a firm’s activities generate negative externalities, its MSC is greater than its MPC. In equilibrium, the Marginal Private Benefit (MPB) will be equal to the firm’s MPC, and hence the MPB < MSC. Hence, the final output for the consumer yields less to the society than what it costs to society. Thus, it can be deduced that production is...
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