Chapter 13: Problem 1

Do market demand curves reflect positive externalities? Why or why not?

Short Answer

Expert verified

Market demand curves typically do not reflect positive externalities, as they are based on private benefits and costs rather than social benefits and costs. This can result in a suboptimal allocation of resources, as consumers do not fully consider the additional benefits accrued to third parties or society as a whole. Therefore, government intervention might be necessary to achieve socially optimal outcomes in the presence of positive externalities.

Step by step solution

Definition of externalities and market demand curves

An externality is a cost or benefit that arises from an economic activity and affects the stakeholders not directly involved in that activity. Positive externalities are the benefits to society that are not captured in the market price of a good or service. A market demand curve shows the relationship between the price of a good or service and the quantity demanded by consumers at each price level.

Private and social costs

Private costs are the costs incurred by a producer or consumer directly involved in the production or consumption of a good or service. Social costs, on the other hand, are the total costs incurred by society, including both private costs and any external costs (such as negative externalities). In the presence of positive externalities, the social benefit of consumption is greater than the private benefit, as some of the benefits are shared with third parties or society as a whole.

Market demand curves and externalities

Market demand curves are derived from consumers' willingness to pay for a good or service, taking into account only their private benefits. This is because consumers generally make decisions based on their own preferences and individual costs and benefits of consumption.

Do market demand curves reflect positive externalities?

Since market demand curves are based on private benefits and costs, they generally do not fully reflect the presence of positive externalities. As a result, the quantity of a good or service demanded in the market is likely to be less than the socially optimal level, as consumers do not fully consider the additional benefits accrued to third parties or society as a whole.

Conclusion

Market demand curves do not generally reflect positive externalities, as they are based on private benefits and costs rather than social benefits and costs. This can lead to a suboptimal allocation of resources in the presence of positive externalities, which is why government intervention, such as subsidies or public provision of goods with positive externalities, may be needed to achieve socially optimal outcomes.