Quiz 3: The Environment
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The externality is the cost or benefit of an economic activity that spill over onto the society. A positive externality provides a benefit to the society and is called spillover benefit. The classic example of spillover benefit is education. A negative externality provides a cost to the society and is called spillover cost. The classic example of spillover cost is pollution. The presence of negative externality distorts the resource allocation in the sense that they generate an output level which is either greater than or less than socially optimal level. That is the market either under produce or over produce the output. Let us consider the resource allocation between two hypothetical industries: paper industry and beer industry. To simplify the demand and the supply curve of two industries are drawn identically in figure 1 below. Initially, we assume no pollution and the equilibrium price and quantity with no spill over cost is P and Q. This is also the socially desirable output level. Figure Now suppose that the paper industry thought it would be too expensive to prevent pollution and stars dumping its waste in adjacent river. This causes the water pollution but saves the cost of maintaining anti polluting measure to the firm. Hence, the cost of controlling pollution decreases and this reduces the cost of production of the paper firm. This increases the paper supply and the market supply curve for paper industry shifts rightward to S', as shown in the left panel of the above figure. This increases the equilibrium output to Q'. However, this output is not the social optimal as the firm does not take into account the social cost or the spill over cost of the pollution and go on producing more than the social desirable output. Hence, in this case pollution causes overproduction of output. Now, let's consider the beer industry. The firm in this industry uses water from the river as their input. After the water pollution they need to purify the water before they use it into production. This added an extra cost to their production and increases the cost of production. A rise in production cost shifts the supply curve of the beer industry to the left. Now, the equilibrium output in the beer industry is Q', which is less than the social desirable output Q. Thus, pollution causes underproduction of goods in the economy. Here we saw the externality in one market not only shifts the pollution cost onto the society, but also, distorts the allocation of resources in the other market. Here, there is an under allocation of resources. Therefore, the most economists thought that pollution distorts the resource allocation in the economy.
The externality is the cost or benefit of an economic activity that spill over onto the society. A positive externality provides a benefit to the society and is called spillover benefit. The classic example of spillover benefit is education. A negative externality provides a cost to the society and is called spillover cost. The classic example of spillover cost is pollution. The spill over cost of pollution includes the cost of poorer health of the people in the society. Also, the cost of decreased productivity of the people, higher health care expenses and cleaning cost, damage to building and forests, aesthetic displeasure, and so on. The other cost of pollution is in the cost of litter, solid waste, inefficient use of scarce resources. As pollution poses cost to others; the polluters generally not willing to bear the cost of pollution unless they are paid a good incentive to do so. So unless we are compensated for or not forced by law we will not be willing to pay anything and sacrifice nothing to eliminate all pollution.