Cambridge International as and a level Economics Ebook

correct externalities
As referred to in 
Chapter 6
, an externality occurs when 
the benefi ts or costs to society diff er from the benefi ts or 
costs to the individual who is responsible for them. Using 
terminology referred to earlier, this is when the marginal 
social benefi ts (MSBs) diff er from the marginal private 
benefi ts (MPBs); equally, it is when the MSCs are not equal 
to the MPCs.
Such diff erences occur in four situations:
1 
negative externalities in production
2 
negative externalities in consumption
3 
positive externalities in production
4 
positive externalities in consumption.
Intervention to correct externalities takes many forms 
including:
■
use of indirect taxes
■
various types of regulation
■
property 
rights
■
provision of information
■
pollution 
permits
■
subsidies.
Recent interest has also focused on behavioural insights 
and the so-called ‘nudge’ theory.
Let us now consider how these interventions 
might be applied in each of the four situations where 
externalities occur.
Negative production externalities
Th
is is a particularly common form of market failure. 
A typical example is the case of a fi rm that pollutes the 
environment as a result of its production processes. 
An indirect tax (ideally a green tax) would normally be 
imposed on the individual or fi rm that causes the negative 
externality. Th
is is consistent with the so-called ‘polluter 
pays’ principle.
In 
Figure 8.4
, where there is no government 
intervention, the equilibrium occurs at point E, where 
supply, 
S
1
, which is given by marginal private cost 
(MPC), equals demand, 
D
, given by marginal private 
benefi t (MPB). However, if external costs are taken into 
account, then the supply curve becomes 
S
2
or marginal 
social cost (MSC). Th
e vertical distance between these 
two supply curves is marginal external cost (MEC). Th
e 
socially optimal level of output is now equal to 
Q
2
, where 
S
2
cuts the demand curve. At this socially optimal level of 
output, the marginal external cost is equal to the vertical 
distance AB.
P
2
P
1
P
3
Price
Quantity
Q
2
Q
1
S
2 
= MSC = MPC + MEC
S
1
= MPC
A
C
E
B
D
= MPB
Figure 8.4 
External costs and use of indirect taxation
Quantity
0
Price
S
D
Q
2
Q
1
P
2
P
1
S
1