Negative externalities A negative externality is a cost that is suffered by a third party as a result of an economic

transaction. In a transaction, the producer and consumer are the first and second parties, and third

parties include any individual, organization, property owner, or resource that is indirectly

affected. Externalities are also referred to as spillover effects, and a negative externality is also

referred to as an external cost.

Some externalities, like waste, arise from consumption while other externalities, like carbon

emissions from factories, arise from production.

Externalities commonly occur in situations where property rights over assets or resources have

not been allocated, or are uncertain. For example, no one owns the oceans and they are not the

private property of anyone, so ships may pollute the sea without fear of being taken to court. The

importance of establishing property rights is central to the ideas of influential Peruvian

economist, Hernando De Soto, who has widely argued that successful market economies need a

widespread allocation of property rights to enable economies to fully develop.

Showing negative externalities

Negative externalities

An external cost, such as the cost of

pollution from industrial production, makes

the marginal social cost (MSC) curve

higher than the private marginal cost

(MPC).

The socially efficient output is where MSC = MSB, at Q1, which is a lower output than the

market equilibrium output, at Q.

Net welfare loss

Net welfare loss

Net welfare loss can exist in two situations.

Firstly, it exists when the marginal cost to

society of a particular economic activity,

such as manufacturing 200,000 computers,

is greater than the marginal benefit to

society. Secondly, it can exist when the

marginal benefit of a given economic

activity, such as producing 50,000m

computers, is greater than the marginal

cost.

1

The first situation can occur when the market produces 'too much', and the second when it

produces 'too little'.

Example

For example, If we consider a manufacturer

of computers which emits pollutants into

the atmosphere, the free market equilibrium

will occur when marginal private benefit =

marginal private costs, at output Q and

price P.

The market equilibrium is at point A.

However, if we add external costs, the

socially efficient output is Q1, at point B.

At Q marginal social costs (at C) are greater than marginal social benefits (at A) so there is a net

loss. For example, if the marginal social benefit at A is £5m, and the marginal social cost at C is

£10m, then the net welfare loss of this output is £10m - £5m = £5m. In fact, any output between

Q1 and Q creates a net welfare loss, and the area for all the welfare loss is the area ABC.

Therefore, in terms of welfare, markets over-produce goods that generate external costs.

Remedies

Market Based Solutions:

Market-based solutions try to manipulate market forces to reduce the externality, by exploiting

the price mechanism. One such market-based solution is to extend property rights so that third

parties can negotiate with those individuals or organisations that cause the externality. British

economist and Nobel Prize winner, Ronald Coase argued that the establishment of property

rights would provide an efficient solution to the problem of externalities. As long as one party

can establish a property right, there will be a bargaining process leading to an agreement in

which externalities are taken into account.

If property rights cannot be established, such as with the air, sea, or roads, then the only two

options are:

1. We learn to live with externalities, or:

2. Government intervenes on our behalf through taxes or direct controls and

regulations, such as:

a. Taxing polluters, such as carbon taxes, or taxes on plastic bags.

b. Subsidizing households or firms to be non-polluters, such as giving grants for

home insulation improvements.

c. Selling permits to pollute, which may become traded by the polluters.

d. Forcing polluters to pay compensation to those who suffer, such as making noise

polluting airports pay for double-glazing.

e. Road pricing schemes, such as the Electronic Road Pricing (ERP) system in

Singapore, which is a pay-as-you-go, card-based, road-pricing scheme.

f. Providing more information to consumers and producers, such as requiring that

tickets to travel on polluting forms of transport, especially air travel, should contain

information on how much CO2 pollution will be created from each journey.

Positive externalities A positive externality is a benefit that is enjoyed by a third-party as a result of an economic

transaction. Third-parties include any individual, organization, property owner, or resource that

is indirectly affected. While individuals who benefit from positive externalities without paying

are considered to be free-riders, it may be in the interests of society to encourage free-riders to

consume goods which generate substantial external benefits.

Most merit goods generate positive externalities, which beneficiaries do not pay for. For

example, with healthcare, private treatment for contagious diseases provides a considerable

benefit to others, for which they do not pay. Similarly, with education, the skills acquired and

knowledge learnt at university can benefit the wider community in many ways.

Unlike the case of negative externalities, which should be discouraged to achieve a socially

efficient allocation of scarce resources, positive externalities should be encouraged.

Encouraging positive externalities

One role for government is to implement economic policies that promote positive externalities.

There are two general approaches to promoting positive externalities; to increase the supply of,

and demand for, goods, services and resources that generate external benefits.

Increasing supply

Government grants and subsidies to producers of goods and services that generate external

benefits will reduce costs of production, and encourage more supply. This is a common remedy

to encourage the supply of merit goods such as healthcare, education, and social housing. Such

merit goods can be funded out of central and local government taxation. Public goods, such as

roads, bridges and airports, also generate considerable positive externalities, and can be built,

maintained and fully, or part, funded out of tax revenue.

Increasing demand

Demand for goods, which generate positive externalities, can be encouraged by reducing the

price paid by consumers. For example, subsidizing the tuition fees of university students will

encourage more young people to go to university, which will generate a positive externality for

future generations.

The ultimate encouragement to consume is to make the good completely free at the point of

consumption, such as with freely available hospital treatment for contagious diseases.

Government can also provide free information to consumers, to compensate for the information

failure that discourages consumption. If individuals are fully informed about the benefits of

consuming goods and services that generate external benefits, they may develop a better

understanding of the product and demand more of it. For example, public information

broadcasts, such as aids awareness programmes, can reduce ignorance, and encourage the use of

condoms.

An additional option is to compel individuals to consume the good or service that generates the

external benefit. For example, if suspected of having a contagious disease, an individual may be

forced into hospital to receive treatment, even against their will. In terms of education,

attendance at school up until the age of 16 is compulsory, and parents may be fined for

encouraging their children to truant.

Net welfare loss

The existence of a positive externality means that marginal social benefit is greater than marginal

private benefit.

Net welfare loss

For example, in

considering the

market for

education, free

markets would

supply quantity Q

at price P. If the

external benefit is

included, the

socially efficient

output rises to

quantity Q1.

By consuming only quantity Q, marginal social benefit is above marginal social cost, and more

of the good should be consumed. At Q, the marginal social cost is A (Q – A), and the private

benefit is also A (Q – A) but the marginal social benefit is C (Q – C). Therefore, if only Q is

consumed, there is an opportunity cost to society, which is represented by the area of welfare

loss, A, C, B.

Merit goods The market for merit goods is an example of an incomplete market. Merit goods have two basic

characteristics:

Firstly, unlike a private good, the net private benefit to the consumer is not fully recognized at

the time of consumption. Net private benefit is the utility from gained from consumption less any

private cost incurred, and equates to net consumer surplus. In the case education, which is

widely considered to be a merit good, pupils and students cannot possibly know the specific

private benefit to them of getting good grades at school, college or university. They will be well

aware of the sacrifice required to study, but will not know the benefits to them in terms of a

future job, salary, status and skills. Therefore, with education, as with other merit goods, there is

a significant information failure in terms of expected benefits.

Secondly, while consumption of a merit good also generates an external benefit to others, from

which society gains, this is unlikely to be known or recognized at the point of consumption.

Given that decisions to consume are driven by self-interest, it is unlikely that this external benefit

will be taken into account when the consumer of a merit good evaluates its worth. For example,

an individual student is generally not motivated to study hard in order to benefit others later in

life, although everyone associated with them will benefit from their education in some way.

Beneficiaries include future employers and all those who consume the products supplied their

employer, their family, and friends. The better job they obtain, the more tax they will pay, and

the greater the benefit to those who receive welfare benefits and transfers. However, putting a

value on these external benefits is impossible, especially at the point of learning.

Healthcare

Healthcare is also regarded as merit good. For example, although it is not possible to know

exactly when the benefit will arise, inoculation against a contagious disease clearly provides

protection to the individual, and yields a private benefit. There is also an external benefit to other

individuals who are protected from catching the disease from those who are inoculated!

However, few would choose inoculation simply to protect others!

The supply of merit goods

Economic theory predicts that while markets may form to supply some merit goods, total supply

will be insufficient to achieve a socially efficient level of consumption. A number of factors

explain the lack of merit goods in a free market economy.

There is a significant level of information failure, in terms of both the private and the external

benefits resulting from consumption of merit goods. For example, there is likely to be

considerable information failure in terms of recognizing the benefit to themselves, and to others,

of regular health checks, eye tests, or visits to the dentist.

There may also be considerable time lags in deriving the benefit of a merit good. This is clearly

the case with education, where the private benefits may not occur for ten or twenty years after

consumption.

Given that individuals are driven largely by self-interest, the external benefit of consuming a

merit good is not likely to be included in the private calculation of buyers and sellers. However,

society needs as many people as possible to be educated and healthy so that all individuals can

receive the maximum external benefit.

Finally, individuals and families on low incomes are not likely to be able to pay the full market

price of merit goods, and will under-consume. For example, to continue to supply private

education, tuition fees must be set to cover the full costs of supply. However, private fees are

likely to be well in excess of what many low income families could afford to pay.

Merit goods

Because of the above, it is likely that merit

goods will be under-consumed and under-

supplied.

In a free market, the supply curve reflects marginal private cost (MPC), and the demand curve

reflects the marginal private benefit (MPB), or utility, expected from consumption.

However, the expected marginal private benefit is likely to be much greater than the actual

benefit. This is because individual consumers of merit goods fail to perceive the true benefit to

them. Indeed, there is an information failure, which results in the consumer under-consuming.

Hence, on the graph, the actual marginal private benefit is higher, and to the right of the expected

benefit curve.

Merit goods and positive consumption externalities

With education, few students will know with any precision the benefit to themselves of being

educated, let alone the benefit to others. In other words, there is imperfect information.

Merit goods - adding the external benefit

The demand curve reflects consumers’

expected benefit, but most benefit arises in

the future and is unknown at the time of

consumption. Market equilibrium is at A,

with Q merit goods supplied.

If the under-perceived private benefit is added to the expected benefit, then the demand curve

will reflect the actual benefit, with equilibrium at B.

Finally, adding the external benefit - the positive impact on third-parties - gives the marginal

social benefit, at C (Q1), which is the socially efficient level of output.

Remedies for the under-supply of merit goods

Markets frequently fail to allocate sufficient resources to the production of merit goods; hence

governments may need to intervene and create an environment in which markets for merit goods

can form. The basic options are to adopt measures that increase consumer demand, or increase

supply.

Measures to increase supply

Market theory suggests that supply will increase in one of two ways; either following a rise in

price, which provides an incentive for private firms to enter the market, or by a subsidy, which

reduces costs of supply. While a higher price encourages supply, it also discourages demand and

results in less demand for a merit good. Hence, a subsidy would encourage both supply and

demand.

Government could also choose to by-pass the market and take over responsibility for supplying

the socially efficient quantity of merit goods. This is what happens with state education,

healthcare, and national insurance.

Alternatively, the government could pay the cost of supplying a merit good, and request that the

individual consumer makes an out-of-pocket contribution to these costs, such as with prescription

charges.

Government could also cover some of the costs of private sector provision, such as providing

free training for doctors, nurses and teachers, who may then work in private hospitals and

schools.

Government could also encourage private firms to enter the market by offering incentives. For

example, private hospitals could be given cash incentives to increase the number of hospital beds

available to National Health Service (NHS) patients, and private schools could be given grants to

take state school pupils.

Measures to increase demand

A second approach to merit goods is to increase demand for them. This can be achieved either

through lowering price, which would expand demand, or by shifting the position of the demand

curve.

What price to set for a merit good is an issue facing policy makers. One option is to provide the

service free at the point of consumption, as currently exists with NHS treatment. This would

expand demand to its maximum, but it may encourage over-consumption, with the system

becoming clogged-up with free riders and malingerers, diverting resources from the genuinely

sick and needy.

With education, a voucher system is a frequently proposed option to encourage demand for merit

goods provided by the private sector. This system can be used to create a quasi market. Typical

voucher schemes involve parents being allocated education vouchers, which they are then free to

spend on any school of their choice. Parents can combine the vouchers with their own finance to

pay for a place at any school – either state or private. Supporters of vouchers argue that they

allow a market to be completed effectively and in a way that enables poorer families to have

access to the best schools. Over time, this will drive up the quality of all schools as they compete

with each other for scarce vouchers.

Follow link for article on educational vouchers.

Finally, demand for a merit good could be increased providing knowledge, so that the consumer

can make a more informed appraisal about the benefits of consuming merit goods.

Regulation

Whenever government allocates resources on behalf of citizens, a potential principal-agent

problem may arise. This means that public sector managers and employees may act in their own

interests, and not in the interests of the government or taxpayer. In order to solve this problem,

regulation may be necessary to ensure that the highest possible standards are achieved. For

example, government may establish educational standards such as the national curriculum, and

may set national targets for reducing hospital waiting lists. Regulations can help achieve

standards in public healthcare and education that would occur in a more competitive

environment.