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External costs and external benefits

Question:

(a)         Explain the impact of external costs and external benefits on resource allocation;

(b)         Why are public goods not produced in sufficient quantities by private markets?

(c)         Which of the following are examples of public goods (or services)? Delete the incorrect option

Explain your choice.

  (i)       The Judicial system       ..................................................................................................................... Yes/No

  (ii)      Pencils       ........................................................................................................................................... Yes/No

  (iii)     The quarantine service    ................................................................................................................. Yes/No

  (iv)     The Great Wall of China....................................................................................................................... Yes/No

  (v)      Contact lenses       ............................................................................................................................. Yes/No

Summary:

The question is about externalities affecting resource allocation, public goods and their implication on the profit of a firm have been answered.

Answer:

(a)     External costs and benefits, known as externalities; can affect resource allocation in both positive and negative manner. A negative externality can increase the cost of operations, and this is mainly due to the harmful effect of one industry's or economic agent's operation on the other. An example may be the effect of a factory dumping its waste in a river, which adversely affects the operations of fishing industry. On the other hand, a positive externality helps reduce the cost of operation in one sector due to favourable operation in other sector. An example in case is a highly educated person living in a locality and teaching people about good effects of sanitation, which leads to a decline in healthcare costs of the locality.

(b)  The private markets take into account only the direct benefits accruing to the producer in the calculation of profit optimization. However, public goods by their very nature are non-rival and non-excludable. This generates positive externalities and hence creates social benefits which are not taken into account by the private producers. This leads to an under-provision of public goods in the private market.

(c)

  • Yes
  • No
  • Yes
  • Yes
  • No

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