1(a) the economic interpretation of externality (using diagrams and examples) including the difference between the positive

and negative externalities [9] An externality exists when the action of an individual(s) or firm(s) inescapably affects the welfare of another

individual(s) or firm(s) . The affected individual may be a consumer, giving rise to what is termed consumption externality, or a producer, giving rise to what is termed production externality. According to Baumol and Oates,(1970), an externality is present whenever some individual s(for example individual A) utility or production relationships include real variables, whose values are chosen by others(persons, corporations, governments)without particular attention to the effects on As welfare. Externalities can be positive as well as negative. P. Mohr and L Fourie (2004) define negative externality as a cost experienced by someone who is not a party to the transaction that produced it. Examples of negative externalities can be the installation of a new pool which causes some ones yard to get flooded; the production of steel which causes smoke to fill the air of surrounding communities; the sound of someones stereo that keeps someone up at night The diagram below illustrates a negative externality in the case of steel manufacturing. The graph shows a cost and benefit of making steel. The MPC is Marginal Private Cost Curve and MPB is Marginal Private Benefit Curve. When there is absence of externality the quantity will be at Qp. But the production of steel will cause more cost to exist upon the society such that beside private costs there will also be external costs shown by Marginal Social Cost curve (MSC).
MS C MPC

Cost benefit

MPB Output QP

P. Mohr and L Fourie (2004 further define positive externality as a benefit experienced by someone who is not a party to the transaction that produced it. For example beautiful private garden that passers-by enjoy seeing. The figure below shows expenditures on the extraction of oil . The extraction of oil will lead to a positive externality because it creates more profitable opportunities for other firms. This is indicated by the Social Marginal Cost which is below the Private Marginal Cost Curve

Price of oil

PMC SMC

P1 P2

PMB

Quantity of oil Q1 Q2

1(b) the consequences of existence of externalities on the operation of the market system Externalities are market activities that cause both positive and negative effects to the operation of the market. Externalities lead to outcomes which are less than optimal ones in terms of prices charged and outputs produced (that is less than Pareto Optimal level). The optimal level is given by the price and output that is obtained under conditions that would exist in a perfectly competitive general equilibrium. The market must operate in a level at which marginal social benefit given by price is equal to marginal social cost given by the monetary value of the resources costs in all markets. Therefore externalities lead to a deviation from this standard According to Michan(1971) negative externalities will result in the level of output that is greater that the Pareto Optimal amount and the market price that is less than the marginal social cost. He further asserts that the positive externalities will give rise to a level of out put that is less than Pareto optimal since the market prices is not capturing all the benefits being generated from the production activity. The diagram below illustrate the effects of pollution from the production of Aluminium and how it affects the market operating at Pareto Optimal level. The optimal level of output is where there is the intersection of the demand curve and social cost curve . however the figure illustrate the socially optimal level which is below the market equilibrium quantity Q1

Price of Aluminum

Social Cost Cost of Pollution Optimum Equilibrium Supply (Private Cost)

Demand (Private Value)

0 Q1

Q2

Quantity of Aluminum

R. Cordato (2007) argues that technology spillover is a type of positive externality that exists when a firms innovation or design not only benefits the firm, but enters societys pool of technological knowledge and benefits society as a whole. The diagram below illustrate the effect of positive externality to the market operating at Optimal level. In this case the manufacturing of robots gives a rise to the optimal level which is more than the equilibrium quantity. The market is producing a smaller quantity than desirable. And finally the social costs of production are less than the private costs to producers and consumers.

Price Of Robot

Value of Technology Spill over

Supply (Private Cost) Social Cost

Equilibrium Optimum

Demand (Private Value)

0 Q1

Q2

Quantity of Robots

1 (c) The strategies used by the government to solve the externality problems [6] The government has three main methods it can use to cope with negative external costs. These are taxes, emission charges and marketable permits. The government can levy a tax equal to the marginal external cost. Such a tax is called a Pigovian tax. Imposing a tax equal to the marginal external cost shifts the private supply curve so that it is the same as the marginal social cost curve. Emission charge is a price per unit of pollution that the government sets and the polluter pays. Through marketable permits each polluter is given a pollution limit. If it reduces its pollution below this limit, it can sell the excess reduction to other firms who then do not need to reduce their pollution by this amount. Marketable permits provide a sharp incentive to find technologies that reduce pollution However in dealing with positive externalities the government uses the following four methods to attain a more efficient outcome. These are public provision, private subsidies, voucher and patenting and copyrights Through public provision, a public authority that receives its revenue from the government can manufacture the good or service. The government would produce the efficient quantity and then set the price at a level that demanders will buy. Private subsidies are payments from the government to the private producers of the good or service. A subsidy increases the supply of the good and thereby increases the quantity produced. A voucher is a token that the government provides to households, which they can use when they buy specified goods or services. A voucher will shift the demand curve so that the quantity will be the efficient amount. Patents and copyrights are government-sanctioned exclusive rights granted to the inventor of a good, service, or new production technique for a given number of years. Patents and copyrights help ensure that the inventor will personally profit from the invention and so increase the incentive to innovate, which benefits society.

2(a) the price elasticity demand for Domestic air travel and factors most likely to account for its value 2, 5 Mohr. P and Fourie L (2004) define price elasticity of demand as a measure used to capture the sensitivity of consumers demand for a good or service in response to changes in the price of that particular good or service. Goods with elasticities less than one in absolute value are inelastic or price insensitive. Goods with elasticities greater than one in absolute value are elastic or price sensitive. Factors which are likely to cause price elasticity of demand to be -2.5 can be substitutability, time, proportion of income and type of goods (that is either a necessity or luxury good) The value -2.5 indicates that the airline industry has got a large number of substitutes. Consumers have a wider choice of transport which can be in the form of passenger trains, public transport and private cars The value also indicates that the domestic air travel is regarded as a luxury good or service in Zimbabwe. The more the good is considered to be a luxury rather than a necessity, the greater is the price elasticity of demand. The service has this value maybe due to the fact that the price is regarded as high in the Zimbabwean market. The principle of Ceteris Paribus states that other things equal, the higher the price of a good relative to consumers incomes, the greater the price elasticity of demand. 2(b) the pricing policy required for the airline industry to increase its revenue [6] The air line industry has got a price elasticity of demand which is above 1 and an income elasticity of demand above 1 indicating that it is very elastic. This therefore gives evidence that a small proportion of a change in price will give rise to a bigger proportion of change in quantity demanded and a small proportion of change in income will result in a bigger proportion of change in quantity demanded. Mohr. P and Fourie L (2004) advice that if a producer is faced with an elastic demand for their product, they can increase total revenue by lowering the price of the product. When the price of the product decreases there will be a proportionately greater increase in the total quantity demanded. Total revenue will thus increase. Therefore the air line industry will have no incentive in raising the price of its product since this will result in the decrease of the consumers real income and a decrease in quantity demanded will be proportionately greater than a the increase in the price of the product, so total revenue will fall.

2(c) the interpretation of the income elasticity value for domestic air travel and its implications to Zimbabwean context. The value of income elasticity is positive. This means that an increase in income is accompanied by an increase in quantity demanded of the domestic air line travel. In other words it shows that a decrease in income is accompanied by a decrease in quantity demanded. This also indicates that it is a normal good. Normal goods have a positive income elasticity of demand. Since normal goods are classified into necessities and luxury goods. This value of 5.0 indicates that this is a luxury good. When the income elasticity of demand is greater than 1, that is when the percentage change in quantity demanded is greater than the percentage change in income the good is called a luxury good. In applying this value to the Zimbabwean context this tells us that the Zimbabwean consumers regard the domestic airline as a luxury transport. Therefore they will only consider using it when their level of income rises. A small proportion of decrease in the level of income will lead to a bigger proportion of Zimbabwean consumers quitting the use of the domestic airline transport.

BIBLIOGRAPHY Baumol, William. 1965. Review of Buchanan (1969) Cost price and Choice, in the Journal of Economic Literature. Vol.VIII No.4 Mohr .P and Fourie L (2004) Economics for South African Students 3 Edition, Van Schaik Publishers, RSA R. Cordato (2007) Efficiency and Externalities in an Open ended Universe, Ludwig Von Mises Institute, Alabama, USA
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