Slides Structure Private, External and Social Costs/Benefits Externalities and Market Failure Negative Production Externality Negative Consumption Externality Positive Production Externality Positive Consumption ExternalityPrivate costs + External costs = Social costs 9 Private costs The private costs are those costs that are paid for by someone who produces or consumes a good or service. se For example, the driver of a car pays for the insurance, road tax, petrol and the cost of purchasing the car. BD external costs The external costs are the negative side-effects of production or consumption incurred by third parties, for which no compensation is paid. For example, a car driver does not pay for the cost of the congestion and air pollution created when driving the car.B® Social costs The social costs are the total costs to society. 1 The true cost of a car journey is called the social cost. There is a market failure because the private costs (of driving) do net represent the true costs (of driving) to society. Dewnlcaded by Rashid okays ([email protected])a Private benefits + external benefits = Social benefits q Private benefit The private benefits are those that accrue solely to the individual making the action, = When a person has a vaccination against tuberculosis, they receive the private benefit of being immune to the disease. 2 External benefit External benefits are the positive side-effects of production or consumption incurred by third parties. When a person has a vaccination against tuberculosis, other people are also protected from this highly contagious disease. a aPIveeeeg Oe PA nginy Cui nagIVs uiseEsE. 3 Social benefit The social benefits of a decision are all of the benefits that accrue from that decision. © The true benefit of the vaccination is called the social benefit. This is an example of market failure because there are external benefits to society of aS vaccination programmes. If vaccinations were left to the choice of individuals, they would be under-consumed, mainly due to the price that would be charged for them.Gurious Externalities Education ‘An externality is when consumption or production of a good has external effects on 3" parties, apart from the consumer and producer. This means someone not involved in the consumption or production of the good is affected positively or negatively. Externalities are a type of market failure as it misaligns the cost/benefit of consumers or producers with that of society's casts/benefits, disrupting optimal resource allocation in the market.Qurious Education Externalities To understand this concept and undertake economic analysis on externalities, we need to learn Economic terms describing the misalignment of private and social benefits and costs Marginal private benefit (MPB) is the benefit a consumer gains from consuming the next unit of the good Marginal social benefit (MSB) is the total benefit society gains from consuming the next unit of the good. Marginal private cost ((MPC) Is the cost a firm incurs from producing the next unit of the good, Marginal social cost (IMSC) Is the total cost society incurs fram producing the next unit of the good.au ous Education External Costs & Benefits MSB includes MPB but also the additional benefits to society of consuming or producing one extra unit of the good. The additional benefits are called external benefits Marginal Social Benefit = Marginal Private Benefit + Marginal External Benefit MSC includes MPC but also the additional costs to society of consuming or producing one extra unit of the goad. The additional costs are called the external costs Marginal Social Cost = Marginal Private Cost + Marginal External CostExternalities Example The private cost of extracting oil to oil companies is lower than the sacial cost to society. When an oil spill happens, many third parties are adversely affected (e.g. fishing & tourism industries, wildlife seers). The oil companies do not have to pay these third parties when extracting the oil. Hence, ail companies tend to overproduce (extract) oil despite society may prefer for them to produce less.Marginal Benefit Marginal Benefit (MB) is how much utility a person gains from consuming the next unit of the good. The utility you gain from consuming a good gradually decreases when you have more and more of it, This is why you are willing to pay high prices to obtain the good when quantity is low, vice versa. Hence, the marginal benefit curve is analogous to the demand curve such that more is demanded when the price is low. Price QuantityQurious Education Marginal Cost Marginal Cost (MC) is how much it costs a producer to supply one more unit of the product, In general, if the market price can cover the cost of producing the next unit, then the firm (or society) will supply it. The market price for the next unit will be higher when more needs to be produced. Hence, the marginal cost curve is analogous to the supply curve, such that more is i supplied when the price is high. a ‘QuantityMaximizing Net Benefit Price The net benefit from producing ‘one more unit ofthe goodisthen hig simply MB — MC, rot When market quantity is at Q,, marginal benefit is higher than marginal cost. This means consuming/producing the next unit will increase total benefit of society (because benefits > cost). Hence, net benefit is not maximised. Qurious Education Mc (s)Maximizing Net Benefit Price Similarly, when quantity is at Q,, marginal cost is higher than marginal benefit, meaning less should be consumed/produced to reduce loss of total benefit, to maximise net benefit. Qurious Education MC (s) ‘OutputMaximizing Net Benefit Price Asa result, net benefit is maximised at the market equilibrium where MB=MC. It is analogous to where demand = supply in the free market, which is also the allocative efficient point that maximises producer and consumer surplus. When the market is not operating at equilibrium, this phenomenon is called Market Failure. urious Education Mc (s)Qurious tye Educati: Externalities wanes We call the these examples a Negative Production Externatity as over-production of the product leads to a negative effect on third parties (e.g. society/others) Here are the other types of externalities: Positive Consumption Externality is when a good/service is under-consumed because its consumption will benefit third parties. Negative Consumption Externality Is when a good/service is over-consumed because its consumption will harm third parties. Positive Production Externality is when a good/service is under-produced because its production will benefit third parties.Externalities Some other examples of negative production externalities... oaExternalities Ina negative production externality, the firm incurs lower cost than society as they do not need to pay for external costs (e.g, environmental pollution). This is indicated by having MPC on the right of MSC (remember supply shifts to the right when cost is lower). Benefits (demand) is not affected and will still be aligned, hence marginal social benefit (MSB) = marginal private benefit (MPB). urious Education MpB=MSB OutputExternalities ‘To optimise their total benefit, the firm will produce the quantity indicated at the private optimum where MPC=MPB (Q2). This Is higher than the desired amount of output for society at Q1, where MSC=MSB. Hence, the total benefit for saciety is not maximised as MSC is higher than MSB at Q2, In the oil spill example, this is because the firm does not need to pay for the negative consequences dealt — to third parties when extracting (producing) oil. Qurious Educa’ Output