No 119: Exam Focus 1 - Externalities

IF YOU have looked through Module 1 past papers, you will notice this is the most common topic for essays, especially negative externalities.

Here are some important points to remember about externalities:

1) Essential to any definition is the idea that externalities describe effects on other people rather than either the producer or consumer of that particular good.

Some examples:

• consumers of cigarettes affecting people who are not smoking
• drinkers taking up hospital beds which could be used by cancer patients
• drivers of electic cars contributing to lower CO2 emisions for everyone else
• a chemical factory using techology to clean up its pollution into a river used by fishermen

2) Social costs are NOT the same as negative externalities (same with social benefits / positive externalities).

Consider......

Total chocolate bars you have = Galaxy bars you have + Snickers you have
Total chocolate bars is NOT only just how many Galaxy bars you have.

Total exams you take this year = Number of A level exams + Number of IELTS exams
Total number of exams is NOT only the number of A level exams

Total costs of something to society = All the costs affecting the producer and the consumer + All the costs affecting other people
Therefore, total costs to society are NOT only all the costs affecting other people

Since total costs of something to society are social costs
And all the costs affecting the producer and consumer are private costs
And all the costs affecting other people are negative externalities (also called external costs)

Social costs = Private costs + Negative externalities

3)  Problems with free market quantity of a good happen if it either has a very high amount of negative externalities or a very high amount of positive externalities.

All goods have some positive externalities and some negative externalities. However, if these are relatively small, the free market should be doing an acceptable job in providing the good.

4) Be careful what you call a "merit good" or "demerit good".

Trains are not a merit good. Why not? Well, while they do have a high amount of positive externalities (reduced road congestion for example), it seems like the free market is often able to provide enough trains.

Petrol is not a demerit good. Why not? Well, while it does cause a lot of negative externalities, it also has quite a lot of positive externalities - for example, allowing transportation of goods to shops or allowing the production of plastic.

Please let me know if this has been useful, and if there is another topic (micro or macro, AS or A2) that you would like me to write about.