Question

VIII. Externalities and public goods and Common resources (Chapter 16) a. Positive and negative externalities what are they and examples b. How to correct for negative externalities. c. Concept of excludability and rivalry in consumptions d. Problems with public goods e. Problems with common resources.

Answer 1

a. Economic activities that have positive effects on unrelated third parties are considered positive externalities. As we learned above, they may be present in the form of production or consumption externalities.

Positive production externalities are positive effects that originate during the production process of a good or service. An example of this could be 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 externalities are positive effects on third parties that originate from the consumption of a good or service. A possible example could be your neighbor’s flower garden. She probably cultivates the plants solely for her own pleasure, yet you can still enjoy the beauty of the flowers whenever you walk by.

Negative externalities

Negative externalities are defined as economic activities that have negative effects on unrelated third parties. They can be divided further into negative production and negative consumption externalities.

Negative production externalities

Negative production externalities are negative effects that originate during the production process of a good or service. The most common example of this kind of externality is the pollution caused by firms during the production of their goods. Pollution affects the entire population, however as long as companies are not held accountable for it, they have no incentive to reduce their economic impact (because that would be more expensive).

Negative consumption externalities

Negative consumption externalities are negative effects that arise during the consumption of a good or service. To give an example, we can revisit your neighbor. If she likes to play loud music in the middle of the night, a negative externality on your part could be sleep deprivation. Once again, she may not take this into account as the consequences do not directly affect her

b. If there are negligible transactions costs, as long as someone owns the rights to the air around the steel mill, the efficient outcome will prevail. For example, if the steel mill owns the rights, then the individuals that live around the mill will be willing to pay the steel mill not to produce--up to the cost that they are incurring from health care, reduced aesthetic appeal of the air, etc. This amount that they are willing to pay becomes an opportunity cost for the steel mill if they produce. Thus they will cut production to the optimal level. On the other hand, if the people own the air, then the steel mill would have to pay them that same amount for the right to produce. Thus the negative externality is directly added to the steel mill's marginal cost.

Another way to solve the negative externality problem is to simply tax the producer the amount of the negative externality. This adds to the producers marginal cost and will cause them to reduce output.

We can either set the appropriate quantity directly through a quota, price floor, or price ceiling. More commonly, governments address the externality through a tax or subsidy. A tax that addresses a negative externality by taxing the good instead of the actual external cost is called a Pigouvian Tax.

c Two important concepts when we are thinking about classifying goods as private or public goods are the concepts of rivalry and excludability.

A good is rivalrous if one person consuming it ‘uses it up’, meaning someone else cannot consume it. If you fill your car with petrol and then use it up, nobody else can use that petrol. If you eat a sandwich nobody else can eat it. Those are rivalrous goods. However if you create a beautiful painting that people enjoy looking at, the painting is not rivalrous as it doesn’t matter how many people look at it, you aren’t ‘using it up’.

A good is excludable if you can prevent somebody from using it. If you need a ticket to go into the cinema then it’s excludable. Street lighting is not excludable though because anybody walking down the street at night benefits from it, you can’t make the light shine on some users and not on others.

d. Many public goods may at times be subject to excessive use resulting in negative externalities affecting all users; for example air pollution and traffic congestion. Public goods problems are often closely related to the "free-rider" problem, in which people not paying for the good may continue to access it. Thus, the good may be under-produced, overused or degraded. Public goods may also become subject to restrictions on access and may then be considered to be club goods; exclusion mechanisms include toll roads, congestion pricing, and pay television with an encoded signal that can be decrypted only by paid subscribers.

e. Overuse of common resources often leads to economic problems such as the tragedy of the commons, where user self-interest leads to the destruction of the resource in the long term, to the disadvantage of everyone.