Revision:Externalities

TSR Wiki > Study Help > Subjects and Revision > Revision Notes > Economics > Externalities

Externalities are effects of production or consumption of a good on a third party, who is not directly involved in the activity. Externalities can be internalised by bringing the cost home to the producer or consumer so that they have to pay for clean-up.

Externalities cause market failure if the cost/benefit to third parties is not taken into account. The wrong quantity of goods is produced, leading to a loss of welfare.

Negative Externalities

The quantity Q1 to Q2 is overproduction.

Negative externalities occur when the production or consumption of a good causes costs to a third party. Examples include:

• Smoking - passive smoking causes health problems for people who do not consume cigarettes themselves.
• Pollution - causes health problems and long term environmental problems.
• Alcohol abuse - clean-up costs of fights, vomiting etc. as well as long term health problems from binge drinking.

Positive Externalities

The quantity Q1 to Q2 is underproduction.

Positive externalities provide benefits to people not directly concerned with the production or consumption of the good. Examples of positive externalities include public transport, vaccinations and education.

Internalising the externality

1. Taxes
2. Regulation
3. Subsidies
4. Property rights
5. State-provided goods

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