Question

Explain a positive and negative externality that you have recently consumed. Please relate your answer to the characteristics of elasticity. Why does the government have to get involved when an externality is present in the market?

Answer 1

An externality is when a cost or benefit of an action affects a third party. An example of a negative externality is when an individual is smoking and I would inhale the smoke. This passive smoking would affect my health and is therefore an example of negative externality. An example of a positive externality is when an individual gets a vaccine for a disease and this would benefit me because the risk of me coming in contact with the disease reduces.

When there is a negative externality, the more elastic sectors can be taxed so that the negative externality can be internalized. Tax helps reduce the production so that optimal level of output is produced. Similarly subsidy can be used to encourage more production of goods with positive externality.

A government has to get involved when there is an externality because the private benefit or cost is always lesser than the social benefit or cost respectively. So for instance, when there is a negative externality, the firms do not take into account social cost and therefore end up producing more than the optimal level. Similarly, individuals do not take into account social benefit and only consider the private benefit.