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 externality. b. Positive externality. c. Positive externality. d. Positive externality. e. Negative externality.

Step-by-step solution

Understanding Externalities

Externalities are effects of economic activities that impact third parties who are not directly involved in the activity. Positive externalities occur when the activity provides a benefit to others, while negative externalities occur when it imposes a cost.

Analyzing Overallocation of Resources

Overallocation of resources typically indicates the presence of a negative externality. In a situation where more than the socially optimal amount of a good or service is produced, it often results in negative consequences for society.

Evaluating Tammy's Garden

The installation of a nice front garden by Tammy increases the property values of neighboring houses, which is a positive outcome. This scenario is an example of a positive externality, as it benefits those not directly involved in creating the garden.

Understanding Market Demand Curves

Market demand curves that are too far to the left indicate an under-consumption of a good or service, which usually is the result of a positive externality. Social benefits are higher than what is reflected in market demand, leading to an underallocation of resources.

Underallocation of Resources Analysis

Underallocation of resources occurs when less of a good or service is produced than is socially optimal. This is often a sign of a positive externality, as the benefits are not fully accounted for in the market.

Evaluating Water Pollution Scenario

Water pollution from a factory that forces neighbors to buy water purifiers is an example of a negative externality. This is a cost that results from the production process of the factory, impacting individuals who are not involved in the production.

Key concepts

Understanding Negative Externality

Negative externalities occur when an economic activity imposes a cost on third parties who are not directly involved. Consider the case of a factory releasing pollutants into a river. This pollution might necessitate surrounding residents to purchase water purifiers to ensure their drinking water is safe. Such incidental costs are not accounted for in the factory's production cost, leading to societal costs collectively termed as negative externalities.
These externalities can cause overallocation of resources because the producers are not bearing the full, true cost of their production. Without these costs covered, more resources are dedicated to the activity than is socially optimal. When negative externalities exist, market transactions don't account for these outward costs, leading to a misallocation or overproduction of the good in question.

Understanding Positive Externality

Positive externalities occur when an action benefits others who were not directly involved in the initial economic transaction. Take the example of Tammy's beautiful garden. While Tammy put effort into making her yard beautiful, the benefits spill over to her neighbors by enhancing the aesthetic appeal and potentially increasing property values along the block.
Such externalities lead to benefits that are not fully captured by the market. Therefore, without intervention, the market may under-provide these goods or services, as the person or company creating the positive externalities isn't compensated for the additional benefits provided to others. In a perfect market, these associates would share profits, but due to the non-excludable nature of such benefits, it typically requires external intervention.

Exploring Overallocation of Resources

Overallocation of resources is generally attributed to negative externalities. When external costs are not addressed or internalized by producers, markets produce more than what they should if all costs were accounted for.
This excessive production occurs because the prices of goods do not reflect the full environmental or social costs, like pollution or resource depletion. When producers ignore these costs, they price their products too low, leading to excessive consumption and production. Correcting this misallocation requires intervention, such as pollution taxes or regulations to account for these external costs and reduce production to socially optimal levels.

Exploring Underallocation of Resources

Underallocation of resources often arises with positive externalities. Goods or services that generate additional benefits beyond their buyers are typically underproduced. This is because the market demand curve does not reflect the full value society places on the goods.
A classic example is education. When individuals gain an education, their skills improve, benefiting not just themselves but society at large through higher productivity and innovation. However, since many benefits are indirect and diffuse, they aren't accurately captured in consumer demand, leading to fewer educational services being offered than socially desirable. Solutions may include subsidies or incentives to encourage production up to the level that reflects overall societal value.

Understanding Market Demand Curves

Market demand curves can indicate the presence of externalities. When the demand curve is too far to the left, it typically indicates an under-consumption issue, normally due to positive externalities. The demand curve does not reflect all societal benefits.
As a result, the quantity consumed will be less than the socially optimal quantity. Conversely, when market demand is high due to negative externalities not being accounted for, it reflects an excess supply beyond social desirability. Adjusting these curves to the right level involves market adjustments, such as subsidies for positive externalities and taxes or regulations for negative ones, aligning private incentives with social well-being.