Question

One reason that a market fails is in the presence of externalities (Chapter 18) Discuss two cases of either a negative or positive externality that affects you directly.

• What are the economic outcomes associated with each externality (in terms of surplus/over production etc.)?
• What are some ways that you could intervene to correct these externalities? If your solution requires the government to be involved, discuss why. If not, also describe why! (For full credit please make a reference to Coase's theorem that could be relevant.)

Answer 1

Externality means the economic effect which occurs from the production or the use of goods to other parties or economic units. Externality may be positive or negative, positive externality occurs when the action of one party benefits another party. A negative externality occurs when the action of one party imposes costs on another party.

Lest's discusses two cases of positive externality it may be from production or consumption

Positive Production Externality: Positive production externalities are positive effects that occur during the production process of a good or service. Taking the example of an orchard placed next to a beehive. In this situation, both the farmer and the beekeeper benefit from each other, even though from an economic perspective neither of them has considered the other one’s needs in their decision-making.

Positive Consumption Externality: Positive consumption externality occurs when consumption of a good or services has a positive effect on society. Taking the example of an individual planting an attractive garden in front of his house for his own consumption may benefit other living in the area.

In positive externality, the benefit to society is greater than personal benefit. In both the example the production of honey will benefit the farmer, as well as the beekeeper and consumption of garden, will benefit the society as well. As the examples, we have taken here the create positive externality the government should provide subsidy for promotion of production and consumption as positive externality leads to under production and underconsumption respectively. If we would have taken the example of negative externality then the government should impose a tax on the output to reduce the externality. In both the positive or negative externality the government has an im[ortant role to play.