1. An externality arises when one party directly conveys a benefit or cost to others (Png, 2007), a negative externality arises when one party imposes a cost on another, so the cost of producing a good or service is borne by others likewise a positive externality is when there is a beneficial effect on third parties from the decisions of consumers and producers. Externalities of the positive or negative variety create a problem in the functioning of the market to maximise the total utility of society where utility is defined as the aggregate sum of satisfaction or benefit an individual or society gains from consuming goods or services in an economy (Png, 2007)
In the diagram above the marginal social cost curve (MSC) is above the marginal private cost curve (MPC), this shows a negative externality. Reversely if the marginal social cost curve was below the marginal private cost curve, it would be a positive externality.
With the construction of a new subway to consider, many potential externalities may materialise. Externalities have an opportunity cost associated with the decision; here there are the options of the subway system buying the property around the station or the property owners buying shares in the company. A negative externality may be pollution in the form of air, noise as a result of increased traffic whilst developing the subway, also with commuters once developed. A positive externality would be investment in the surrounding area; business would see increased revenues from more commuters.
Non resolution of externalities result in economic inefficiency and they can only be resolved through direct and deliberate action, benchmark of externalities is economic efficiency resulting in maximisation of net benefits where individual marginal benefit equals individual marginal cost, creation of an externality is a market failure as equilibrium is not achieved, and the most common referred to is the Nash Equlibrium. When a negative externality is present this can result in deadweight loss, which is a net social loss by both parties involved when it is not Pareto optimal and is a measure of the market failure, this situation stops a firm operating at its Production Possibility Frontier which is the most efficient process.
a) By purchasing the surrounding area, people will get a personal utility benefit, creating a producer surplus for the property owners, it is also an incentive to the company to make a more economically efficient level of investment in the success of the subway and environmental regeneration of the area as in the case of Walt Disney in the late 80’s developing the site around Disneyland (UCLA, 1989). This resolution of the externality is the free rider principle, the property owner can raise the price, contributing less than its marginal benefit to resolution of losing the property but this leads to network effects as this will be dependent on the total number of other people affected.
b) Buying shares in the company resolves the externalities through the use of joint action as they cannot merge companies in the area, but the source and recipient of the externalities remain separate entities but they will have to reach agreement on compensation for the externality created.
2. Pensions are relevant when making prospective business decisions; a large part of a company’s service cost is related to the pension and is a future liability for the firm in terms of a payout to the retiree. Money is paid into the pension fund and then invested; returns on investment are credited to the individuals account.
The costs to the employers who have to pay pension contributions for higher staff numbers their costs will rise…will be like an extra tax burden or expenditure – could have a knock on for higher prices, lower wage rises and lower returns for shareholders in order to maintain equilibrium with profits. As it is difficult to calculate the amount to be paid out,