(a) Explain the impact of external costs and external benefit on resource allocation; External costs are costs that are not included in the market price of a good because it's not included in the supply price. Pollution is an example of an external cost if producers aren't the ones who suffer from pollution damages. External costs are types of market failure that causes inefficiency. Example of Production External Cost
Producing chemicals can cause pollution to air and water.
Diagram Showing Effect of External Cost
This diagram shows how the existence of external costs will cause the social marginal cost to be greater than the private marginal cost. Therefore, in a free market there will be overconsumption of the good (Q1). Social efficiency will occur at Q2 where SMC = SMB. External benefits are benefits that are not included in the market price of a good because they are not included in the demand price. Cycling to work helps to reduce the level of pollution and congestion. Therefore other road users have quicker journey times and help to reduce the level of pollution. External benefits are some types of market failure that causes inefficiency. Diagram showing external benefits
This diagram shows how the existence of external benefits will cause the social marginal benefits to be greater than the private marginal benefits. Therefore, in a free market there will be overconsumption of the good (Q1). Social efficiency will occur at Q2 where SMC = PMC. (b) Why are public goods not produced in sufficient quantities by private markets? The economic definition of a public good is anything that is non-rival and non-excludable. Intellectual property and things like software, sound files are considered pure public goods. Although we treat them as private goods, enforced through IP law, they fit the Samuelson definition of public goods and are treated as such in economic theory. Can you say that songs, movies and news articles are not produced...
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