What's covered
Key facts
Externalities
Examples of negative externalities include factory pollution, traffic congestion and late-night noise from a nightclub disturbing residents.
Misallocation of resources
Because externality costs and benefits are not reflected in the market price, goods with negative externalities are overproduced and goods with positive externalities are underproduced.
Externalities
Examples of positive externalities include vaccination (which reduces the spread of illness to others), education and public parks.
Misallocation of resources
Demerit goods like cigarettes and junk food are overconsumed and overproduced in a market economy.
Externalities
Externalities are positive or negative side effects of an economic activity on third parties who are not directly involved in the transaction.
Misallocation of resources
Government may force producers to provide accurate information through labelling, and may run public campaigns to improve knowledge.
Externalities
Negative externalities cause social costs to exceed private costs.
Misallocation of resources
Information failure exists when some, or all, of the participants in an economic exchange do not have perfect knowledge.
Externalities
With a negative externality the market price does not reflect the true social cost, leading to overproduction or overconsumption.
Misallocation of resources
Government policies to correct externalities include taxation and subsidies, state provision, legislation and regulation, and information provision.
Practice questions with answers
A taste of the 22 questions in this topic, answers marked. Sign up to practise the full set with spaced repetition.
In economics, what is an externality?
- •A benefit received by the seller
- ✓A cost or benefit felt by a third party
- •A cost paid by the buyer of a good
- •A tax charged on imported goods
What do economists mean by market failure?
- •When a business makes a loss for a year
- •When a firm leaves the market voluntarily
- ✓When free markets allocate resources inefficiently
- •When prices rise faster than wages each year
Which of these is an example of a negative externality?
- •A firm paying higher wages to its staff
- ✓Late-night nightclub noise disturbing neighbours
- •Lower disease rates after mass vaccination
- •Residents enjoying a well-kept public park
Without government intervention, why may education be under-consumed in a free market?
- •Firms always set its price too low
- •It has no benefits for third parties
- ✓People underestimate its full benefits
- •Too many schools compete for pupils
Why does vaccination create a positive externality?
- •It costs the government money to provide
- •It makes the vaccinated person healthier
- •It raises profits for vaccine makers
- ✓It reduces the spread of illness to others
Why might street lights not be provided by private firms in a free market?
- •Consumers place no value on them
- ✓It is hard to make users pay for them
- •The law bans firms from supplying them
- •They cost nothing to build or run
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