externality assignment

7/28/2019 Externality Assignment

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1(a) the economic interpretation of externality (using diagrams and examples) including the differenc

between the positive and negative externalities [9]

An externality exists when the action of an individual(s) or firm(s) inescapably affects the welfare of anoth

individual(s) or firm(s) . The affected individual may be a consumer, giving rise to what is termed consumptioexternality, or a producer, giving rise to what is termed production externality. According to Baumol an

Oates,(1970), an externality is present whenever some individual s(for example individual A) utility o

production relationships include real variables, whose values are chosen by others(persons, corporation

governments)without particular attention to the effects on As welfare.

Externalities can be positive as well as negative. P. Mohr and L Fourie (2004) define negative externality as

cost experienced by someone who is not a party to the transaction that produced it. Examples of negativ

externalities can be the installation of a new pool which causes some ones yard to get flooded; the production osteel which causes smoke to fill the air of surrounding communities; the sound of someones stereo that keep

someone up at night

The diagram below illustrates a negative externality in the case of steel manufacturing. The graph shows a co

and benefit of making steel. The MPC is Marginal Private Cost Curve and MPB is Marginal Private Benef

Curve. When there is absence of externality the quantity will be at Qp. But the production of steel will caus

more cost to exist upon the society such that beside private costs there will also be external costs shown b

Marginal Social Cost curve (MSC).

Cost benefit

MSC

MPC

MPB

Output

QP


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P. Mohr and L Fourie (2004 further define positive externality as a benefit experienced by someone who is not

party to the transaction that produced it. For example beautiful private garden that passers-by enjoy seeing. Th

figure below shows expenditures on the extraction of oil . The extraction of oil will lead to a positive externali

because it creates more profitable opportunities for other firms. This is indicated by the Social Marginal Co

which is below the Private Marginal Cost Curve

Price ofoil PMC

SMC

P1

P2

PMB

Q1 Q2

Quantity of oil


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1(b) the consequences of existence of externalities on the operation of the market system

Externalities are market activities that cause both positive and negative effects to the operation of the marke

Externalities lead to outcomes which are less than optimal ones in terms of prices charged and outputs produce

(that is less than Pareto Optimal level). The optimal level is given by the price and output that is obtained undconditions that would exist in a perfectly competitive general equilibrium. The market must operate in a level

which marginal social benefit given by price is equal to marginal social cost given by the monetary value of th

resources costs in all markets. Therefore externalities lead to a deviation from this standard

According to Michan(1971) negative externalities will result in the level of output that is greater that the Paret

Optimal amount and the market price that is less than the marginal social cost. He further asserts that the positiv

externalities will give rise to a level of out put that is less than Pareto optimal since the market prices is n

capturing all the benefits being generated from the production activity.

The diagram below illustrate the effects of pollution from the production of Aluminium and how it affects th

market operating at Pareto Optimal level. The optimal level of output is where there is the intersection of th

demand curve and social cost curve . however the figure illustrate the socially optimal level which is below th

market equilibrium quantity Q1

Price of

AluminumCost of

Pollution

Social Cost

Supply

(Private Cost)

Optimum

Equilibrium

Demand

(Private Value)

0 Q 2Q 1

Quantity of Aluminum


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R. Cordato (2007) argues that technology spillover is a type of positive externality that exists when a firm

innovation or design not only benefits the firm, but enters societys pool of technological knowledge and benefit

society as a whole. The diagram below illustrate the effect of positive externality to the market operating

Optimal level. In this case the manufacturing of robots gives a rise to the optimal level which is more than th

equilibrium quantity. The market is producing a smaller quantity than desirable. And finally the social costs o

production are less than the private costs to producers and consumers.

Price

Of Robot

Value of

Technology

Spill over

Supply

(Private Cost)

Social Cost

Equilibrium

Optimum

Demand

(Private Value)

0 Q 2Q 1

Quantity of Robots


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1 (c) The strategies used by the government to solve the externality problems [6]

The government has three main methods it can use to cope with negative external costs. These are taxe

emission charges and marketable permits.

The government can levy a tax equal to the marginal external cost. Such a tax is called a Pigovian tax. Imposin

a tax equal to the marginal external cost shifts the private supply curve so that it is the same as the margin

social cost curve.

Emission charge is a price per unit of pollution that the government sets and the polluter pays.

Through marketable permits each polluter is given a pollution limit. If it reduces its pollution below this limit,

can sell the excess reduction to other firms who then do not need to reduce their pollution by this amoun

Marketable permits provide a sharp incentive to find technologies that reduce pollution

However in dealing with positive externalities the government uses the following four methods to attain a mor

efficient outcome. These are public provision, private subsidies, voucher and patenting and copyrights

Through public provision, a public authority that receives its revenue from the government can manufacture th

good or service. The government would produce the efficient quantity and then set the price at a level th

demanders will buy.

Private subsidies are payments from the government to the private producers of the good or service. A subsid

increases the supply of the good and thereby increases the quantity produced.

A voucher is a token that the government provides to households, which they can use when they buy specifie

goods or services. A voucher will shift the demand curve so that the quantity will be the efficient amount.

Patents and copyrights are government-sanctioned exclusive rights granted to the inventor of a good, service, o

new production technique for a given number of years. Patents and copyrights help ensure that the inventor wi

personally profit from the invention and so increase the incentive to innovate, which benefits society.


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2(a) the price elasticity demand for Domestic air travel and factors most likely to account for its valu

-

2, 5

Mohr. P and Fourie L (2004) define price elasticity of demand as a measure used to capture the sensitivity o

consumers demand for a good or service in response to changes in the price of that particular good or service

Goods with elasticities less than one in absolute value are inelastic or price insensitive. Goods with elasticitie

greater than one in absolute value are elastic or price sensitive.

Factors which are likely to cause price elasticity of demand to be -2.5 can be substitutability, time, proportion

income and type of goods (that is either a necessity or luxury good)

The value -2.5 indicates that the airline industry has got a large number of substitutes. Consumers have a wid

choice of transport which can be in the form of passenger trains, public transport and private cars

The value also indicates that the domestic air travel is regarded as a luxury good or service in Zimbabwe. Th

more the good is considered to be a luxury rather than a necessity, the greater is the price elasticity

demand.

The service has this value maybe due to the fact that the price is regarded as high in the Zimbabwean marke

The principle of Ceteris Paribus states that other things equal, the higher the price of a good relative t

consumers incomes, the greater the price elasticity of demand.

2(b) the pricing policy required for the airline industry to increase its revenue [6]

The air line industry has got a price elasticity of demand which is above 1 and an income elasticity of deman

above 1 indicating that it is very elastic. This therefore gives evidence that a small proportion of a change

price will give rise to a bigger proportion of change in quantity demanded and a small proportion of change

income will result in a bigger proportion of change in quantity demanded. Mohr. P and Fourie L (2004) advic

that if a producer is faced with an elastic demand for their product, they can increase total revenue by lowerin

the price of the product. When the price of the product decreases there will be a proportionately greater increa

in the total quantity demanded. Total revenue will thus increase. Therefore the air line industry will have n

incentive in raising the price of its product since this will result in the decrease of the consumers real incom

and a decrease in quantity demanded will be proportionately greater than a the increase in the price of th

product, so total revenue will fall.


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2(c) the interpretation of the income elasticity value for domestic air travel and its implications t

Zimbabwean context.

The value of income elasticity is positive. This means that an increase in income is accompanied by an increa

in quantity demanded of the domestic air line travel. In other words it shows that a decrease in income accompanied by a decrease in quantity demanded. This also indicates that it is a normal good. Normal goo

have a positive income elasticity of demand. Since normal goods are classified into necessities and luxury good

This value of 5.0 indicates that this is a luxury good. When the income elasticity of demand is greater than 1, tha

is when the percentage change in quantity demanded is greater than the percentage change in income the good

called a luxury good.

In applying this value to the Zimbabwean context this tells us that the Zimbabwean consumers regard th

domestic airline as a luxury transport. Therefore they will only consider using it when their level of income riseA small proportion of decrease in the level of income will lead to a bigger proportion of Zimbabwean consumer

quitting the use of the domestic airline transport.


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BIBLIOGRAPHY

Baumol, William. 1965. Review of Buchanan (1969) Cost price and Choice, in the Journal of Economi

Literature. Vol.VIII No.4

Mohr .P and Fourie L (2004) Economics for South African Students 3rd Edition, Van Schaik Publishers, RSA

R. Cordato (2007) Efficiency and Externalities in an Open ended Universe, Ludwig Von Mises Institute

Alabama, USA

externality assignment

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