Externalities

• Externalties are benefits accured to or cost imposed on third parties not involved in the production or consumption of the good and the third parties do not pay for the benefit received or they are not compensated for the cost incurred
• These are the following types of externalities we will need to understand:
  • Positive Externalities arising from Consumption
  • Positive Externalities arising from Production
  • Negative Externalities arising from Consumption
  • Negative Externalities arising from Production

Study Tip

• You do not need to memorise the definition of externality, but rather you will need to explain how the presence of externalities lead to partial market failure
• You only need to memorise one framework to answer questions relating to the 4 different types of externalties

Understanding Externalities

• In Scarcity, we have learnt that consumers and firms are self-interested, which means that they will consume a good based on their own benefits and cost
  • For consumers, they will attempt to maximise utility (satisfaction)
  • For producers, they will attempt to maximise profits
• However, society may sometime benefit more when more of a certain type of good is consumed and produced as it have spillover effects to the other groups of people
  • When consumers consume education, it will lead to a more productive workforce and more profits earned by firms as people become more highly skilled in their work.
  • When producers perform more R&D, it will also lead to a more productive workforce and more profits earned by firms due to better usage of technology
• Sometimes, consuming and producing some goods also cause negative spillover effects to other groups of people:
  • When consumers consume ciagerattes, the smoke produced will affect the health of others as they are more proned to fall sick. People become less productive in work which causes firms to lose profits.
  • When producers produce electronics, they may pollute the river which affects the health of the citizens staying nearby. They will become less productive in their work and the profits earned by firms will also fall
• As such, the consumption and production of some goods must increase and the consumption of some goods must also decrease to increase societal welfare levels and we can say resources are not allocated efficiently.
• With the framework in the next lesson, we will learn how explain market failure with the consumption of these goods.