Worksheet on Social Benefits

Step 1 - Who benefits from what?

Firms produce goods and services to sell them and get revenue. This revenue is the private benefit to the firm. However, their actions may also lead to external benefits (or positive externalities). These are benefits that others gain from the firm's actions. For example, a company may invest in various energy efficiency projects to save them money. This obviously is a private saving to the firm. However, there is also a external benefit as less electricity has to be generated and emissions of greenhouse gases are reduced.

For each of the examples below, try to identify the private and external benefits from the firm's action.

action	private benefit?	external benefit?
A firm recycles the by-products from production	The reuse of the by-products may cut the firm’s production costs	Reduce pollution and its subsequent effects.
The firm pays for private health care for all employees	Healthier employees can work more diligently and productively, increasing the firm’s production.	Government needs to take less care of its citizens in terms of health care (thus lower taxes and greater benefits in other areas)
The firm introduces an extensive training programme at all levels	An educated labor force will increase its productivity, and hence the firm’s profit.	With a more educated population, society faces numerous benefits, for example: 1) more productive population 2) less crime 3) more educated voters
A new electronic intranet improves communication in the firm and cuts down the amount of traveling	Cut the firm’s costs	Reduce pollution resulting from the travelling
Company cars with smaller engines are specified as standard	Cut firm’s costs as cars with smaller engines are less costly	Due to a decrease in emission as a result of smaller engines, the firm’s action will reduce pollution

Will the firm tend to take account of these external benefits in its decisions? No.

On the diagram below the demand curve is based on just the private benefits of consumption. Draw another demand curve that shows both private and external benefits. Try to show the following:-

• the original price and quantity
• the optimum price and quantity for society
• the difference between the actual consumption and the optimum level of consumption

difference between actual consumption and optimum level of consumption

Step 2 - Benefits in practice

There are many examples in practice where firms or local authorities or governments have set up schemes intended to try to encourage these external benefits. Look at the example of Saarbrucken and answer the following questions.

Write a brief summary of how the solar energy system in Saarbrucken worked.

With the goal of reducing the usage of fossil fuel and the subsequent adverse effects on the environment, Saarbrucken set up goals to reduce such energy use and turn to alternate energy use, one of them being solar energy. However, in order to implement this goal, a substantial amount of money had to be invested, and thus it was subsidized by the government.

To encourage the scheme the government had to subsidize the installation the solar cells. Show the effect of this on the diagram below.

THE MARKET FOR SOLAR CELLS

What are the external benefits that arise from this scheme?
1) Reduction of pollution

2) Research in and increase in the practicability of alternative energy sources (other than fossil fuel)

Go to the UN's Best Practices database to read a case study on Recyling Household Waste in Manila (you need to either view or download the case study as a Word document).

Write a brief summary of how the waste management scheme in Manila worked.
Essentially, the Linis Ganda (waste management) program in Manila hired personnel (who are referred to as Eco Aides), whose job is to go around purchasing recyclables from households. This has been an effective way of managing waste in Manila, as this program has “an economic impact of over US$250,000 per month.”

Fill in the external benefits that you would expect from the scheme:
1) Reduce pollution
2) Recycling decreases the need for new raw materials

Would these benefits have arisen if the management of waste had been left to the free market? No.

What can the government do to ensure that these external benefits occur? What policies are available to them to ensure that they are encouraged?

1. Subsidies
2. Command-and-control policies: regulation (for example, make the schemes that yield external benefits a requirement).

Market Failure: Worksheet on Pollution

Step 1 - The market gets a 'U' - it's failed! Why?

Free markets are the means used in a market economy to allocate resources. Prices go up or down depending on whether resources are plentiful or scarce. Firms supply goods according to how much it costs them to produce the good or service. The higher the cost, the less they will supply.

Show on the diagram below the effect of an increase in the firm's costs. Mark in the equilibrium price and quantity before and after the cost increase.

There are two different types of costs. Most of the costs are private costs. These are costs that the firm has to pay to produce. However, sometimes production also leads to external costs. These are costs that are paid by society, not by the firm. They are often known as negative externalities.

In the table below try to identify each of the costs as private or external costs.

cost	private or external? or Both?
Paying wages	Private
A worker has an accident with a faulty piece of machinery and has to be treated in hospital	Both
The cost of security to prevent equipment being stolen	Private
An accidental leak leads to fish being killed in a local river	External
Paying interest on a loan	Private
A lorry delivering the product has an accident with a car leaving the lorry needing repair	Private
Heavy lorries delivering to the factory cause damage to the road	External

When a firm is producing, will they take account of the external costs? No

Who pays for the external costs? Society (before the government begins to internalize the externalities)

The true or full cost of production should therefore take account of all costs - both private and external. The effect of this is to shift the supply curve as in the diagram above. Draw a new diagram on the axes below to show:-

• the demand curve
• the supply curve including just private costs
• the supply curve including private and external costs
• the equilibrium price and quantity the firm will produce
• the equilibrium price and quantity that the firm should produce if they account for the external costs

Should the equilibrium price be higher or lower taking account of the external costs? Higher

Should the equilibrium quantity be higher or lower taking account of the external costs? Lower

Why do we therefore consider external costs, where they exist, to be a market failure?
We consider external costs as a market failure as it leads to an overallocation of resources to a particular product; the external costs indicate that more products (which are yielding the external costs) are being produced than is socially optimal.

Step 2 - Polluting the atmosphere

Pollution is an external cost. What problems can be caused by pollution?
1) Worsening health conditions of citizens,
2) Global warming
3) Animal extinction (as the environment is destroyed)
4) Decreases aesthetic value of the environment (as nature is destroyed)

Will firms take account of this pollution as a cost? No.

Justify your answer.
The firms will not take account of this pollution as a cost because firms neglect external effects of their actions when they decide how much to supply. If they considered the external costs, their supply would shift inwards (from marginal private cost curve to marginal social cost curve), decreasing their quantity supplied while increasing their costs. As profit-maximizers, this is obviously not the firms’ most favorable scenario; thus, the firms will ignore the external costs.

Who therefore has to deal with the effects of pollution? The government

Step 3 - Help - what can we do?

What policy options are open to the government to deal with pollution?|
1) The Coase Theorem
2) Command-and-control policies: regulation
3) Corrective taxes
4) Tradable pollution permits

One way they might choose to try to deal with the problem might be taxation. Show the effect of a tax on the diagram below:-

To ensure the optimum outcome for society, how much must the tax be?
The tax should be enough to cover the external costs; in other words, the tax should be enough to shift the supply curve to where the marginal social curve should be.