The Deadweight Welfare Loss of Externalities
Economics: Edexcel A A Level, topic 2.1.3
Examples of Externalities
Consumers under and over consume goods and services because they don't take into account the external benefit or cost of their consumption. Firms can under or overproduce goods because they don't account for externalities in their production.
Education
- A good with positive consumption externalities is often called a merit good.
- Education has a positive consumption externality, so it is a merit good.
- In education the MSB>MPB, so it is under consumed in the free market below the socially optimal level.
Petrol cars
- Petrol cars have negative consumption externalities. This means that they are demerit goods.
- Demerit goods are over consumed in the free market. This leads to a deadweight welfare loss to society.
Absence of property rights
- The absence of property rights means that it is not clear who owns what.
- For example, it is not clear who owns the environment or air. This can lead firms to pollute more than is optimal because they do not account for external costs.
- Ronald Coase found that allocating property rights is one way to stop market failures from happening. This is called Coase Theorem.
- The absence of property rights can lead to market failure.
Renewable energy
- Renewable energy has positive production externalities.
- It can replace the use of fossil fuels which can damage the environment - the opportunity cost would be using something negative instead of something neutral.
- Governments have subsidised renewable energy (like wind and solar power) in the US and UK to try to increase production closer to the socially optimal level and deliver a gain in society's welfare.
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Alcohol
- Alcohol has a negative consumption externality.
- Excessive alcohol consumption is linked to crime and antisocial behaviour which the rest of society has to deal with. The consumer doesn't pay the cost that the externality causes leading to the overconsumption of the negative consumption externality.
- The MSB < MPB and this creates a welfare loss unless the government intervenes.
Vaccination
- Vaccination has positive consumption externalities.
- In addition to protecting someone from an illness, vaccination also reduces the risk of that person spreading the illness. As a result, the rest of society is better protected from the illness due to one person's consumption of the vaccine. This is called herd immunity.
Test yourself on The Deadweight Welfare Loss of Externalities
What will firms account for when deciding production?
What will consumers account for when deciding how much of a good or service to consume (assuming no intervention)?
Which of the following is an example of a positive consumption externality?
Which of the following have negative externalities in production or consumption?
What is a good with positive consumption externalities often called?