How does neg/pos externalities effect pricing?

Hey,

I'm doing AS AQA economics.

I really don't get how Negative and positive externalities wrongly price things? or cause overproduction of a good or underproduction? cant some one explain it to me simply please

Hey,

I'm doing AS AQA economics.

I really don't get how Negative and positive externalities wrongly price things? or cause overproduction of a good or underproduction? cant some one explain it to me simply please

In simple terms:

If left to the free market...

• Merit goods (i.e. goods/services which produce a welfare gain) produce positive externalities, whereby the good/service is under-produced/consumed. This is due to the low consumer demand (which the free market mechanism uses to determine a price).

Demand for merit goods is low as a result of social benefit exceeding private benefit. Consumers aren't going to demand more of a good/service if the private benefit (i.e. the personal benefit of consuming the good/service) is low. This low demand is met with low supply (otherwise known as the free market equilibrium/private optimum), and therefore results in a lower price.

To eliminate positive externalities, the government will intervene in the market with the aim of either increasing demand or supply to reach the social optimum.


• The opposite is true for demerit goods (i.e. goods/services which produce a welfare loss); these produce negative externalities, whereby the good/service is over-produced/consumed, and this is due to the high consumer demand.

Demand for demerit goods is high as a result of private benefit exceeding social benefit. Consumers are going to demand more of a good/service if the private benefit is high. This high demand is again met with high supply (the free market equilibrium/private optimumagain), and therefore results in a higher price.

To eliminate negative externalities, the government will intervene in the market with the aim of either decreasing demand or supply to reach the social optimum.


Obviously, looking at the respective diagrams may help with your understanding of this.

I've found that most exam questions which require you to refer to positive/negative externalities will usually ask more about how to achieve the social optimum, as opposed to asking about the price of the good/service in question—so I wouldn't sweat it! But the point of under/over-production is definitely important to understand.

Hope this helped! (somewhat)

Hey,

Helpful as it was, referring demerit goods, you said demand is high due to private benefit exceeding social benefit, isn't it supposed to be Social costs exceeding private costs?

I'm confused.

Whoops, yeah sorry, muddled that up Edited my post.

wohooo, i have hope!