1.3.2 Externalities

• Externalities occur when there is an external impact on a third party not involved in the economic transaction
  • These impacts can be positive or negative and are often referred to as spillover effects
  • These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)
    
    
• External costs occur when the social costs of an economic transaction are greater than the private costs
  • A private cost for the producer is what they actually pay to produce a good/service
  • An external cost (negative externality) is the damage not factored in to the economic activity (for example, generating air pollution when producing electricity)
  • Private cost + external cost = social costs
    
    
• External benefits occur when the social benefits of an economic transaction are greater than the private benefits
  • A private benefit for the consumer is what they actually gain from consuming a good/service
  • An external benefit (positive externality) is the benefit not factored in to the economic activity (for example, someone who studies law enjoys private benefits but society benefits from having strong legal institutions)
  • Private benefit + external benefit = social benefits

• Negative externalities of production are often created during the production of a good/service
  
  
• The market is failing due to over-provision of these goods/services as only the private costs are considered by the producers and not the external costs
  • If the external costs were considered, the quantity of the goods/services provided would decrease and they would be sold at a higher price
    
    
• Marginal analysis in economics considers the cost or benefit of the next unit produced or consumed
  • The marginal private cost (MPC) is the cost of the next unit produced or consumed
  • The marginal private benefit (MPB) is the benefit derived from the production or consumption of the next unit

External costs of production (negative externality) result in an over-provision shown by the gap between Q_opt and Q_e

Diagram Analysis

• The marginal social benefit (MSB) is assumed to be equal to the marginal private benefit (MPB) as the focus is on the producer side of the market
• The free-market equilibrium can be seen at P_eQ_e. This is where the MPC = MSB
• The larger the external costs in production, the larger the gap between the MPC and the marginal social cost (MSC)
• The optimal allocation of resources from society’s point of view, would generate an equilibrium where MSB = MSC. This can be found at P_optQ_opt. There is no market failure at this equilibrium
• The free market is failing due to over-provision of this good/service at Q_e
• The factors of production used to manufacture this over-provision represent a welfare loss to society (pink triangle)
• To be socially efficient, fewer factors of production should be allocated to producing this good/service
• There is an opportunity for government intervention (indirect taxes, legislation, regulation etc.), to force this market to be more socially efficient
• Any intervention that reduces the welfare loss will be beneficial

• Positive externalities of consumption are created during the consumption of a good/service (merit goods)
• The market is failing due to under-consumption of these goods/services as only the private benefits are considered by the consumers and not the external benefits
  • If the external benefits were considered, the quantity of the goods/services consumed would increase and they would be sold at a higher price

External benefits of consumption (positive externality) result in an under-consumption represented by the gap between Q_e and Q_opt

Diagram Analysis

• MSC is assumed to be equal to the MPC as the focus is on the consumer side of the market
• The free-market equilibrium can be seen at P_eQ_e. This is where the MPB = MSC
• The larger the external benefits in consumption (positive externality), the larger the gap between the MPB and MSB
• The optimal allocation of resources from society’s point of view would generate an equilibrium where MSB = MSC. This can be found at P_optQ_opt. There is no market failure here
• The free market is failing due to an under-consumption of this good/service at Q_e
• More factors of production should be allocated to producing the optimal quantity as societal welfare will be gained (pink triangle)
• There is an opportunity for government intervention (subsidies, partial provision etc.) to force this market to be more socially efficient
• Any intervention that gains welfare will be beneficial

• Analysing externalities and the government intervention necessary to correct them is best done by considering real world examples
• Analysis should always include the impact on stakeholders including producers, consumers, government, and relevant third parties
  
  

The Impact of Negative Externalities & Government Intervention

The Impact of Positive Externalities & Government Intervention