SUBJECT: ECONOMICS

GRADE: 11 IB. /NON IB.

TOPIC: EXTERNALITY ANSWER KIT

ACTIVITY 1: ONLINE CLASSES.

DUE DATE: 5-03-2020. APPROACH TO THE QUESTIONS.

Use DEED while answering any question in economics.

D=Define all the relevant terms

E=Explanation (check use of command term from your text book.)

E=Examples (Always give relevant examples)

D=Diagrams, Use appropriate and applicable diagram to the question as a tool to support your arguments. This approach will apply to all questions in written exams.

Assessment Criteria

Level

0. The work does not reach a standard described by the descriptors below. 0

1. There is little understanding of the specific demands of the question. Relevant economic terms are

not defined. There is very little knowledge of relevant economic theory.

There are significant errors. 1–3

2. There is some understanding of the specific demands of the question. Some relevant economic terms

are defined. There is some knowledge of relevant economic theory.

There are some errors. 4–6

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3. There is understanding of the specific demands of the question. Relevant economic terms are defined.

Relevant economic theory is explained and applied. Where appropriate, diagrams are included and

applied. Where appropriate, examples are used. There are few errors. 7–8

4. There is clear understanding of the specific demands of the question. Relevant economic terms are

clearly defined. Relevant economic theory is clearly explained and applied. Where appropriate,

diagrams are included and applied effectively. Where appropriate, examples are used effectively.

There are no significant errors. 9–10

QUESTIONS

1. Explain the meaning of ‘internalizing an externality’? Internalizing the externality means shifting the burden or costs from a negative externality, such as pollution or traffic congestion from outside to inside.(External to internal).This can be done through taxes ,property rights and government subsidies. For example in case of pollution would be pollution rights. So in case of placing the burden (cost of higher pollution) on people breathing air, government would place a monetary tax on pollution. The purpose of internalizing an externality is to reduce the burden or cost of externality by getting people who are producing externality pay for the negative effects

2. Use examples to distinguish between merit and demerit goods.

A Merit good is a good or service that government believes will be under consumed in a competitive free market. When consumed a merit good will generate a positive externality and as such private benefit of consumption is less than the social benefit of consumption .Consumers do not consider the external benefits that spill over to others in society when consuming a merit good, thus causing the merit good to be under provided in the free market. Examples vaccinations for diseases confer protection to individual being vaccinated and it also reduces the chances of others in society becoming infected from the disease. Health care services benefit those receiving the services and has spill over benefits for society in terms of increased productivity, a healthy worker is more productive.

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Demerit goods are goods and services that create negative externalities when there are consumed. Examples, cigarettes, drugs and alcohol, sugar, junk food, petrol and cars. When consumed demerit good will generate negative externality and as such private benefit consumption is greater than social benefit of consumption .Consumers do not consider the external cost that spill over to others in society and as such they are over consumed in free market.

3. Identify two different examples of a negative externality of consumption and explain the

different methods that could be used to correct them.

Negative externalities of consumption refer to the external costs created by the consumers during the course of using the product or service. Negative externalities are associated with demerit goods .Two examples of demerit goods are Alcohol and Cigarettes. Consumption of cigarettes .There is a private benefit to the smoker as he purchases and consumes cigarettes .There is also a cost to society imposed by smokers on the third parties .The consumption of cigarettes affects others indirectly (passive smoking)higher health care costs (higher taxes being paid),less productivity in work place through ill health and so on.

Similarly Alcohol is similar ,in that there is a private benefit to consumer of alcohol as he purchases and consumes it.There is also cost to the society imposed by alcohol drinking on third parties .The consumption of alcohol affects others indirectly (assaults and domestic violence)increased car accidents and other health costs.

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Methods of correcting negative externalities of consumption such as that associated with alcohol and cigarettes.

The allocative efficiency point of consumption can be internalized by decreasing the demand for the product and shifting the MPB left to where it overlaps the MSB curve .This can be achieved through advertising or government regulations

Government regulations

A government can legislate or impose regulations that limit or prevent types of consumption that impose negative spillover effects on third parties; e.g., cigarette smoking and the extra healthcare burden imposed on the taxpayer.

A government can regulate to correct a negative externality of consumption. For example, regulating that cigarettes can only be sold to those aged 18 and over, and that cigarettes cannot be smoked in workplaces, cafes, bars and restaurants will reduce the demand for cigarettes. The demand curve will decrease from D1 = MPB until it overlaps

4 with D2 = MSB, the socially desirable level of demand where the externality has been eliminated (internalizing the externality). As demand decreases, the important effect is that Qe decreases to Q*; and (unimportantly) price reduces from Pe to P* as producers lower their prices to reduce the surplus (excess supply) of the demerit good. See Figure below.

Advertising

Governments often run advertising campaigns in an attempt to persuade consumers from purchasing a product. Anti-gambling, anti-alcohol, and anti-smoking advertisements are examples of advertising campaigns that can be observed in many countries, especially developed countries. Other campaigns will attempt to increase the demand for other goods such as public transport, to reduce the demand for the substitute good (cars and road congestion and pollution).Just as with regulations, the aim of such campaigns is to reduce the demand for demerit goods.

For example, health campaigns and advertisements that demonstrate the harm cigarettes do will reduce the demand for cigarettes. The demand curve will decrease from D1 = MPB until it overlaps with D2 = MSB, the socially desirable level of demand

5 where the externality has been eliminated (internalising the externality). As demand decreases, the important effect is that Qe decreases to Q*; and (unimportantly) price reduces from Pe to P* as producers lower their prices to reduce the surplus (excess supply) of the demerit good. See Figure above.

4. Examine the different policy responses that are available to governments to correct for

the market failures associated with merit and demerit goods.

Definition for merit good refer to qn 2.Merit good government believes will be under consumed in competitive free market. When consumed a merit good will generate positive externality such as private benefit of consumption is less than social benefit of consumption. Consumers do not consider the external benefits that spillover to the others in society when consuming, thus causing merit good be underprovided.

Reasons for under providing merit goods in free market.

Positive externality occurs when an external benefit is created by the consumption of a good. Low levels of income (poverty) in society .Consumers may want to purchase a merit good such as university education but do not have income to access education..

Consumers ignorance .Sometimes consumers will be better off if they consume certain merit goods such as vaccination but may be unaware of the benefits of doing so .Education has positive externalities in that education has social benefits greater than private benefits .An education in free market is expensive .Education without subsidy would mean many individuals could not afford to purchase an education in free market because of peoples low levels of income. Consumers are often ignorant of benefits that accrue from a good education such as increased wages, lower crimes rate and increased economic development.

Such goods (merit goods)government feels that people will under consume and therefore ought to be subsidized or provided free at the point of use that so that consumption does not depend on the ability to pay for the good or services. Examples include vaccinations, health services, and electric vehicles around major cities to reduce the overall pollution produced by the fleet of vehicles.

Third parties and groups that external to the markets are benefiting from the consumption decision without paying a cost .And consumer continues to receive private benefit so that MPB is lower than MSC because benefits are not internalized in free market thus MSB > MSC.

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Advertising

People may be persuaded to purchase and consume merit goods that generate positive externalities of production by government funded advertising campaigns. For example, government funded information campaigns about the benefits of childhood vaccinations (and the harm that can be caused by not vaccinating children) can be found in many countries around the world. The objective is to increase consumer demand for vaccinations. The demand curve (MPB) shifts right, ideally to the point where it overlaps with the MSB curve and Q* is consumed at P*

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Legislation

Greater consumption of merit goods can be achieved by governments if they enact laws that compel individuals to consume them. All developed countries have compulsory schooling. Children and teenagers must attend school on a regular basis up until their late teens. This increases the demand for education. The demand curve (MPB) shifts right, ideally to the point where it overlaps with the MSB curve and Q* is consumed at P*

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Direct government provision

A government can provide the good or service that is creating a positive externality of consumption. A good example of this is that governments will fund K-12 education, healthcare services and hospitals, and vaccination programmes. With the benefits of such merit goods being so great it is generally accepted that such important goods and services cannot be left to the free market to provide.

All such activities are paid for through government funding that comes from taxes. As can be seen in below, direct provision of the good generating the positive externality of production increases the supply of the good (shifts the supply curve – MPC – right) towards the MSC curve. At MSC the socially optimum quantity of the good or service is produced at Q* and the price will decrease from Pe to P*.

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Government funding is required to pay for the direct provision of a good or a per unit subsidy. These funds are raised by the government through tax revenues. Tax revenues have multiple competing claims, each with opportunity costs. For example, to increase R&D spending on national defence systems, health and education services will be reduced.

It is difficult to practically measure the size of the external or spillover benefits that arise from production, and as such it is difficult to calculate which goods and services should receive government support.

Legislation can be tremendously effective if supported with adequate resources. Compulsory schooling effectively increases demand and ensures that education is produced and consumed in quantities that could not be achieved by market-based interventions such as providing subsidies to schools and kindergartens. However, it would be nonsense for the government to enact such legislation without providing the resources necessary to fulfil such demand – i.e., providing and/or funding places in schools for all school children.

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Taken all together, it is thus very difficult for governments to internalise a positive externality of production to where the MPC curve is increased to a point where it equals the MSC, and the allocatively efficient point of production and consumption is achieved in the market. At best such policies will reduce the amount of allocative inefficiency in a market.

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