Externalities

Externalities

The effects that producing or consuming a good/ service has on people who arent involved in the production, buying, selling or consumption of the good or service

These people are often called third parties

Positive externalities

A positive externality (also called external benefit) is an economic activity that creates a positive effect to a third party

Negative externalities 

A negative externality (also called an external cost) is an economic activity that imposes a negative effect on a third party 

Externalities arise 

When private costs and benefits are different from the social costs and benefits 

Private costs

Cost of an activity to an individual economic agent, such as consumer of firm

Example: The cost a firm pays to make a good

External costs

A cost to a third party

Example: If you dropped a wrapper then that creates an external cost to the council as they have to hire someone to pick it up

Social cost 

Private cost + external cost 

Social cost is the full cost borne by society of a good or service 

If social cost is greater than the private cost

Then a negative externality is said to exist

Private benefit

Benefit gained by a consumer or firm of doing something

Example: Enjoyment a consumer gets by going skiing

External benefit 

Benefit to a third party 

Example: factory may invest in new equipment that uses less electricity therefore reducing their impact on the climate 

Social benefit

Private benefit + external benefit

Social benefit is the full benefit received by society from a good or service

If social benefit is greater than private benefit

Then a positive externality is said to exist

Positive externality in consumption 

Goods which impose third party benefits when they are consumed 

Negative externality in consumption

Goods which impose third party costs when they are consumed

Positive externality in production

Goods which impose third party benefits when they are produced

Negative externality in production 

Goods which impose third party costs when they are produced