Question

. Consider a time in your life when you have benefited from an externality and a time when you have suffered from an externality. Make sure to clearly describe your role and the type of externality. What is your opinion about the role of government in each of these situations?Please type answer

Answer 1

Part I: An externality arises when the action of one economic agent affects another economic agent who was not involved in the initial transaction. It is the cost or benefit that a third economic agent incurs but is not compensated for. An externality can be both positive and negative and can arise due to both consumption and production of commodities. Externalities lead to market failure. It causes the deviation of market outcome from perfect competition, as the market cost or benefit differs from social cost or benefit.

A positive externality confers benefits on other economic agents. An individual getting a regular check-up for an infectious disease not only minimizes the severity of his own infection but also decreases the likelihood of others getting infected by the disease through his contact. This is an example of a positive externality that has benefitted me. An alternative example of a positive externality that is encountered is when an individual house owner spends on the maintenance and beautification of his house, he increases the market value of the nearby houses as well.

A negative externality imposes costs on other economic agents. Air pollution is a common negative externality that affects everyone. Pollutants from factories affect public health negatively, thus imposing a social cost. Passive smoking is another example of a negative externality, where an individual smoker negatively affects the health of the people in his vicinity.

Part II: In the presence of an externality, the social cost or benefit differs from the private cost or benefit. Cost or benefit associated with externalities is not reflected in the market outcome. In this scenario, the government has a huge role to play. To maximize social welfare, the government should ensure that the marginal social benefit equals the marginal social cost.

In the case of negative externalities, marginal social cost(MSC) is higher than marginal private cost(MPC). So, the government should design policies in such a way that MPC = MSC. In the case of the negative externality arising from pollution, the government can introduce regulatory policies that decrease the output of the polluting firm. It can tax the firm, set emission standards, introduce pollution permits, etc such that MPC equals MSC.

In the case of positive externalities, Marginal social benefit (MSB) is greater than Marginal private benefit(MPB). SO, such externalities are beneficial for society. The government should then subsidize those industries that result in positive externalities to encourage increased output from such sectors.

Thus, in the presence of externalities, the market fails and the government has a huge responsibility to maximize social welfare.