Question

Match each of the following characteristics or scenarios with either the term negative externality or the term positive externality. a. Overallocation of resources. b. Tammy installs a very nice front garden, raising the property values of all the other houses on her block. c. Market demand curves are too far to the left (too low). d. Underallocation of resources. e. Water pollution from a factory forces neighbors to buy water purifiers.

Short answer

a. Negative, b. Positive, c. Positive, d. Positive, e. Negative

Step-by-step solution

Understanding Externalities

Externalities are indirect effects of economic activities. A negative externality results in undesirable effects for others (e.g., pollution), while a positive externality benefits others (e.g., improved community aesthetics).

Analyze Each Characteristic or Scenario

Let's examine each scenario given in the exercise to determine if they represent a negative or positive externality.

Identify Negative Externalities

For each scenario: - Overallocation of resources: This is often associated with negative externalities because too many resources are being used, typically where the social costs are higher than private costs. - Water pollution from a factory: This is a negative externality because the pollution harms neighbors, forcing them to incur extra costs.

Identify Positive Externalities

For each scenario: - Tammy installs a very nice front garden: This raises property values for her neighbors, creating a positive externality. - Market demand curves are too far to the left: This implies not enough resources are allocated, usually indicating a positive externality since the social benefit exceeds private benefit. - Underallocation of resources: This is typical of positive externalities where not enough resources are allocated to achieve a socially optimal outcome.

Key concepts

Negative Externalities

Negative externalities occur when an economic activity imposes costs on third parties who are not involved in the exchange. This can happen when the production or consumption of goods and services affects individuals who did not choose to incur that cost.

When businesses or consumers fail to account for these external costs, it often results in an overallocation of resources. Essentially, more resources are tied up than what is socially optimal, leading to inefficiencies. For example, if a factory pollutes a river, the downstream effects force residents to purchase water purifiers, burdening them with costs not reflected in the pricing of the factory's products. This results in too many resources being dedicated to pollution control by individuals, rather than the factory.

In essence, the costs of negative externalities are borne by people who did not make the consumption or production choice. Addressing these requires intervention, such as regulation or taxation, to internalize the external costs.

Positive Externalities

Positive externalities occur when an individual or firm's actions result in benefits to others who were not involved in the initial buying or selling decision. This often leads to situations where the social benefit exceeds the private benefit.

When Tammy installs a beautiful garden, for instance, her neighbors enjoy the increased aesthetic value and potentially higher property values at no extra cost to themselves. In this case, the market naturally underallocates resources because individuals and firms don't reap the full benefits of their actions. This often means that fewer gardens are planted than would be ideal.

Positive externalities can also result in market demand curves appearing too far to the left, indicating a lower-than-optimal demand. Since these benefits aren't captured in the pricing mechanism, goods and services producing positive externalities may be under-provided. Government incentives or subsidies are often used to encourage more of these beneficial activities.

Resource Allocation

Resource allocation refers to the distribution of resources across various activities and sectors to optimize societal welfare. Efficient resource allocation is crucial for ensuring that resources are used where they provide the most benefit to society as a whole.

In the presence of externalities, resource allocation can become skewed. For negative externalities, this often means overallocation of resources, where more resources are consumed than is socially beneficial. The social cost exceeds the private cost, signaling resource inefficiency.

Conversely, positive externalities can lead to an underallocation of resources. Here, the social benefits outweigh the private benefits, causing fewer resources to be devoted to the activity than is desirable. Ideal resource allocation must consider these external costs and benefits, potentially requiring policy intervention to align private incentives with social optimality.

Market Demand Curves

Market demand curves illustrate the total quantity demanded of a good at various price levels. They are fundamental in understanding how prices and quantities are determined in a market economy.

However, externalities can distort these curves. In the case of negative externalities, market demand curves might not fully capture the true social cost, often leading supply to exceed the point of overall societal benefit. Hence, too much is consumed.

For positive externalities, market demand curves may be too far to the left, indicating a lower demand than is beneficial for society. Here, the true social value is greater than what the demand curve suggests, leading to under-consumption of the good or service. Adjusting for these disparities is essential to ensure that demand curves reflect both private and social preferences, enabling optimal resource distribution.