ECF6105 Economic Analysis: Externalities and Government Intervention

This essay provides an economic analysis of externalities, specifically focusing on the negative externalities associated with not wearing a helmet while riding a bicycle or motorcycle. It discusses how this behavior imposes costs on society, including increased healthcare expenses, unemployment benefits, and potential permanent disability. The essay explains how the presence of negative externalities leads to market failure, necessitating government intervention to restore a socially efficient outcome. It explores the use of taxes and fines as policy instruments to internalize the external costs and encourage helmet use, referencing examples of countries with mandatory helmet laws. The analysis incorporates economic diagrams to illustrate the market dynamics and the impact of government intervention in correcting the externality. The document is a student contribution available on Desklib, a platform offering study tools and solved assignments for students.

Running Head: ECONOMIC ANALYSIS FOR BUSINESS
Economic Analysis for Business
Name of the Student
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1ECONOMIC ANALYSIS FOR BUSINESS
Table of Contents
Introduction................................................................................................................................2
Externalities related to not wearing helmet................................................................................2
Government intervention to correct the externality...................................................................4
Conclusion..................................................................................................................................6
References..................................................................................................................................7

2ECONOMIC ANALYSIS FOR BUSINESS
Introduction
Externality is the benefits or costs imposed on the third party not directly or indirectly
involved in consumption or production activity. The paper evaluates the external cost
imposed on the society when a rider does not wear helmet. It takes into consideration the
immediate cost after getting injured from an accident as well as the indirect cost that society
has to bear because of this activity (Baumol & Blinder, 2015). As a result of negative
externality, number of accident and hence, injury per accidents are more than optimal level.
A counteractive policy in response to this externality is to impose a tax or fines on person for
not wearing helmet. The paper examines the efficiency of such policy with some real world
example of countries those already have made compulsory to wear helmet while riding.
Externalities related to not wearing helmet
A helmet is supposed to protect the rider from sustaining severe injury in head in case
accidents happened. A rider should wear a helmet in times of riding bicycle. Researches
reveals that wearing helmet reduces the possibility of severe head injuries up to 74 percent
during accidents with moto vehicles (Levmore, 2014). A person by not wearing helmet not
only harm himself but also imposes additional cost on the society. In this context the issue of
negative externality needs to be discussed.
Negative externality is defined as an additional cost is incurred from an economic
transaction and is suffered by a third party (Hubbard, Garnett & Lewis, 2012). When a
bicycle rider without wearing helmet met with an accident, then first the person is picked off
to the spot of accidents and is then taken to hospital. Because of bare head, the person is
likely to get deeper injury then that would occur with helmet. Consequently, there is a higher
expense for this person than that would occur with helmet. The sustained injury might
prevent the person to join his regular profession and hence need unemployment benefits

3ECONOMIC ANALYSIS FOR BUSINESS
(Frank, 2016). The head injuries might cause a permanent disability and impose additional
cost of unemployment on the society.
This explains why the society need to pay extra for recklessness of someone. This
recklessness imposes additional cost on other members of the society. The person does not
realize the external cost of such behavior and therefore, the activity of not wearing helmet
accounts for negative externality (Baumol & Blinder, 2015).
Figure 1: Market scenario and negative externality from not wearing helmet
(Source: as created by author)
Figure 1 depicts the market scenario with the presence of a negative externality. The
demand curve is shown as DD. When externality is present on the production side then the
demand curve reflects marginal benefits to the society. The supply curve is SS. In a
competitive market, the supply curve represents marginal private cost as well as marginal
social cost (Beeks & Lambert, 2018). However, with a negative externality marginal social
cost is different from marginal private cost and lies above the marginal private cost. In an
unregulated market, equilibrium outcome is where marginal benefit and marginal private cost
intersects. This is point A in the diagram the socially efficient output if Q* and corresponding

4ECONOMIC ANALYSIS FOR BUSINESS
efficient price is P*. The socially optimum outcome is however at the intersection of
marginal social cost and marginal benefit. The socially efficient equilibrium point is B. The
quantity and price associated with socially efficient equilibrium point is Q1 and P1
respectively. This shows the goods or service with a negative externality is thus overproduced
in the market.
Similarly, when a rider does not wear helmet the cost of accident is not only imposed
on the person but also on the society. The additional health expenditure might in in form of
additional health expense by the government when taken to municipal or government
hospital, disability that might be resulted from serious injuries and such others (Roach, Harris
& Codur, 2015). The person suffers more intense injuries from not wearing helmets than that
would otherwise be.
Government intervention to correct the externality
As discussed above, in an unregulated market presence of negative externality results
in more output than that socially desired. This is the situation where free market fails to attain
an efficient outcome and is known as market failure. In order to restore socially efficient
outcome, government need to intervene in the market (Bland & Nikiforakis, 2015). The
objective of the government is to internalize the external cost and thus help to achieve an
efficient and feasible outcome. The two commonly used instrument to correct market failure
are tax and subsidy. The use of suitable instrument depends on the nature of externality.
In case of negative externality, the appropriate policy is to impose a tax on the activity
that generates negative externality. A tax equivalent to the external cost completely
internalizes the cost of externality leading to socially desirable outcome (McKenzie & Lee,
2016). In order to encourage bicycle rider to wear helmets government should impose a tax
on those not wearing helmets. The effectiveness of such tax however depends on the cost-

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benefit analysis after taxation. If the benefits from not wearing helmet is less than cost of
paying tax, then only an individual considers of wearing helmet and not paying tax.
Figure 2: Correction of helmet externality through tax
(Source: as created by Author)
One solution to the problem of negative externality is the imposition of tax. The tax is
designed to make the individual to bear the full social cost of the activity. The magnitude of
imposed tax should equal the difference between the marginal social cost and marginal
private cost (Sieg, 2016). In case of external cost generated because of not wearing helmet, a
tax in the form of additional fines should be implemented. Rider once caught without helmet
should be subject to additional payment in form of fine or surcharges.
Figure 2 describes correction of market failure through imposition of tax. Initially the
marginal private cost is lies below the marginal social cost. The demand curve represents
marginal cost as usual. Consequently, there is a higher tendency to accidents per rides than
that is socially optimum. Now, suppose a tax in form of fine or surcharge is imposed for

6ECONOMIC ANALYSIS FOR BUSINESS
those not wearing helmets. These riders now have to pay a fine for not having helmet while
riding. This increases the cost of not wearing helmet shifting the marginal private cost
upward. The marginal private cost with fine coincide with marginal social cost. The benefits
of not wearing helmets is merely having a set hair after the ride (Levmore, 2014). The benefit
falls short of the additional cost of not wearing helmet. Once riders are encouraged to wear
helmets to avoid the tax, accidents per ride reduces moving towards socially optimum.
Therefore, fines or tax equivalent to external cost correct the market failure by internalizing
the external cost.
This is the reason why some countries have laws that make helmet-wearing
compulsory. Australia and New Zealand have compulsory helmet laws to reduce accidents
and injuries among bicycle riders. The jurisdiction in Canada and US have made it mandatory
to wear helmet for all age groups (Le Grand & New, 2015).
Conclusion
The paper discusses negative externality in context of wearing helmet. Riders without
helmet tend to suffer more severe injuries than those with helmet. This not only harm the
rider alone but also has incremental cost on the society. The injured person when taken to
government hospital raises the health cost. Other costs of sustained injury are unemployment
benefits and possibility of permanent disability. The presence of negative externality lead to
market failure, which calls for government intervention. Government should impose tax or
fine for not wearing helmet to correct the externality. Many advanced nations already have
legislation mandating helmet for bicycle or motorcycle.

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References
Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Cengage
Learning.
Beeks, J. C., & Lambert, T. (2018). Addressing Externalities: An Externality Factor Tax-
Subsidy Proposal. European Journal of Sustainable Development Research, 2(2), 19.
Bland, J., & Nikiforakis, N. (2015). Coordination with third-party externalities. European
Economic Review, 80, 1-15.
Frank, R. H. (2016). Cash on the table: Why traditional theories of market failure
fail. Journal of Economic Behavior & Organization, 126, 130-136.
Hubbard, G., Garnett, A., & Lewis, P. (2012). Essentials of economics. Pearson Higher
Education AU.
Le Grand, J., & New, B. (2015). Government paternalism: Nanny state or helpful friend?.
Princeton University Press.
Levmore, S. (2014). From Helmets to Savings and Inheritance Taxes: Regulatory Intensity,
Information Revelation, and Internalities. U. chi. l. REv., 81, 229.
McKenzie, R. B., & Lee, D. R. (2016). Microeconomics for MBAs. Cambridge University
Press.
Roach, B., Harris, J. M., & Codur, A. M. (2015). Microeconomics and the Environment.
Sieg, G. (2016). Costs and benefits of a bicycle helmet law for
Germany. Transportation, 43(5), 935-949.