Question

Suppose that producing a bicycle generates no environmental degradation, while buying and riding a bicycle (consumption) help reduce greenhouse gas emissions. In contrast, producing, buying and driving a car do generate greenhouse gas emissions. Based on this information, for each economic activity, first discuss whether there is externality and what type of externality it is and explain why (e.g., production/consumption of cars/bicycles leads to positive/negative/no production/consumption externality because … … …). When explaining your reasoning, make sure you relate your specific answer to the definition of externalities. Then, for each economic activity given above (e.g., production/consumption of cars/bicycles), compare private costs and benefits with the true cost and benefit to society

Answer 1

Bicycle case :

There is no externality in production . This means that production of bicycles has no effect on third party who are not involved in this production process or no harm on environment around is caused . Consumption of bicycles causes generation of positive externality . This is because due to greenhouse gas emission reduction the benefit to society of using a bicycle exceed the benefits enjoyed by the individual consumers of the bicycle . There is a benefit to third party for an economic transaction or consumption . The marginal social benefit is higher than marginal pivate benefit , hence social optimum outcome is higher than market equilibrium outcome . As for example another good that produces positive externality to society is education .

Car case :

Here both production and consumption of car causes negative externality . This is because producing, buying and driving a car do generate greenhouse gas emissions . There is externality is production which means marginal social cost is higher than private marginal cost of production , if this externality is accounted for then supply of cars fall because socially optimum quantity produced is lower than market production . Externality in production affects the supply curve . Same happens during consumption . Someone buying and using a car causes adverse effects on other by polluting environment , which is is negative externality in consumption , the private benefit is higher than social benefit from car consumption . Externality in consumption affects the demand curve . The social optimum is lower than free market equilibrium when externality is internalized .