EXTERNALITIES IN PRODUCTION AND CONSUMPTION

 EXTERNALITIES IN PRODUCTION AND CONSUMPTION

Question 3 A) Answer the following question for each of the following examples: (i)

smoking by individuals; (ii) toxic waste production by firms; (iii) research and development

by a high-tech firm; and (iv) individual vaccination against communicable illness. Is there an

externality? If so, describe it, including references to whether it is positive or negative and

whether it is a consumption or production externality.

Introduction

Externalities arise whenever the actions of one economic agent directly affect another

economic agent outside the market mechanism. There are conditions for efficiency in

consumption and production and overall economic efficiency. These conditions involve

marginal rates of substitution (MRS) and marginal rates of product transformation (MRPT).

The conditions were derived on the assumption that there were no external effects in

consumption and production. However, this may not be so always. Consumption and

production may be subject to externalities. The externalities could be positive or negative.

Positive externalities are externalities that involve external benefits while negative

externalities involve external costs. Positive production externalities lead to under production

while negative consumption externalities lead to over consumption. Positive consumption

externalities lead. Negative production externalities lead to over production. Positive

consumption externalities lead to under consumption.

Example of Externalities

(i) Smoking by individuals

This is a case of Negative consumption externality. When an individual’s consumption

reduces the well-being of others who are not compensated by the individual. Thus, when a

person smokes they expose those near them to a higher risk of diseases such as lung cancer

and asthma among others. This calls for regulation that seeks to protect non-smokers

including setting up of smoking zones in designated areas. This may reduce the consumption

of cigarettes by individuals.

(ii) Toxic waste production by firms

This is a Negative Externality in Production. An example is that of a paper milling firm that

produces paper and the toxic waste is dumped into a river. The firm maybe doing well

however the effects of the toxic waste may be too much. The riverside residents and the

fishes and the aquatic life in the river are hurt by the waste.

(iii) Research and development by a high-tech firm

This is a Positive Externality in Production. The high tech firm will provide comprehensive

research that will lead to inclusive and sustainable development. The firm will also benefit

from improving its technological capacity and be more effective and efficient in future

engagements.

(iv) Individual vaccination against communicable illness

This is a Positive Externality in Consumption. The welfare of any person in a particular

neighbourhood depends not only on whether he is vaccinated but also on whether the people

in the said neighbourhood have been vaccinated so that the communicable diseases are not

spread.

Question 3 B). Caffeine is a highly addictive drug found in coffee, tea, and some soda.

Unlike cigarettes, however, there have been very few calls to tax it, to regulate its

consumption, or to limit its use in public places. Why the difference? Can you think of

any economic arguments for regulating (or taxing) its use?

Continued use of tobacco and excessive consumption of coffee, tea and some sodas are

significant contributors to the global epidemic of non-communicable diseases. As a

consequence, they contribute, as well, to excess health care costs and productivity losses.

Taxes specific to such products, known as excise taxes, reduce consumption of these products

and thereby diminish their adverse health consequences. Although such taxation has

historically been motivated primarily by revenue generation, governments are increasingly

using these taxes to discourage unhealthy consumption.  Thus, taxation is an effective

smoking control policy tool that not only helps to reduce consumption of cigarettes. 

Exercise taxes generally result in higher prices for consumers, reducing demand for taxed

products. The size of the reduction and whom prices most affect depend on consumers’ price

elasticity of demand (the percentage change in the quantity demanded resulting from a 1%

price increase). The cross price elasticity of demand can be. Described as measure of

responsiveness of the demand for a good towards the change in the price of a related good. It

is always measured in percentage terms.

Price elasticity is a function of whether consumers treat the good as a necessity or a luxury

item, how much of a consumer's income is spent on that good, and the availability of

substitutes. The difference between taxation for cigarette is that there are minimal substitutes

unlike with coffee, tea, water, juice, soda and other beverages. With substitutes for each other

like tea and coffee, the cross price elasticity will be positive, i.e. if the price of coffee

increases, the demand for tea increases. 

On the other hand, in case the goods are complementary in nature like pen and ink, then the

cross elasticity will be negative, i.e. demand for ink will decrease if prices of pen increase or

vice-versa.