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Explain the concept of externalities and use it to show why market failure might occur. Using one example, (e.g. road congestion/pollution) show how governments might approach the problem and evaluate the policy alternatives.
What are externalities?
Externalities are present and common in virtually every area of economic activity. They are seen as the knock on effects or "spill over" (Sloman 000) of the production and/or consumption of goods and services for which no appropriate compensation is paid.
Externalities can be either positive or negative; obviously positive can be desirable and negative undesirable. According to Sloman (000) positive externalities are also known as external benefits and negative, external costs. Thus the full costs to society of the production of any good are
PRIVATE COSTS FACED BY FIRMS + EXTERNALITIES OF PRODUCTION.
The full benefits to society from the consumption of any good are
PRIVATE BENEFITS ENJOYED BY THE CONSUMER + EXTERNALITIES OF CONSUMPTION.
According to Sloman, when assuming the market is perfect there are four major types of externality.
1. External costs of production. (Negative externalities)
When a factory or company dumps waste into a river or pollutes the air, the company bears costs but so does the public. This shows that the marginal social costs of production exceed the marginal private costs. This can cause problems in capitalist countries (Sloman 000) as nobody has legal ownership of the rivers or air hence nobody has the right to force another to stop polluting or using these resources.
To overcome these problems control is usually left to the government or local authorities. Governmental controls include the ability to levy fines and heavy taxes where appropriate to discourage polluting and other negative externalities.
. External benefits of production. (Positive externalities)
The example Sloman gives for this is that if a bus company spends money on training drivers and those drivers transfer to coach and haulage companies. The bus company has lost money in training these individuals as they no longer have use for them where as the coach company has saved money due to not having to train them and society has also benefited.
. External costs of consumption.
This is where other people than the consumer have certain effects levied on them. Good examples of these are if a person eats a chocolate bar but drops the wrapper on the floor, pollution from cars or noise pollution from stereos. Consumers create externalities when they purchase and consume goods and services. In these situations marginal social benefit of consumption will be less than marginal private benefit of consumption and this leads to the service/product been over consumed. Without government intervention the good/service will be under-priced and the negative externality will not be taken into account and thus a loss of economic welfare.
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