1.3.2 Externalities

private costs

costs incurred by producers or consumers directly involved in a transaction or economic activity

external costs

costs imposed on third parties who are not part of the transaction or activity

social costs

represents the total costs of an economic activity, including both private and external costs

social costs =

private costs + external costs

in negative externality cost of production diagram, if external costs were considered, what would happen to the Q of goods and services provided and the price

quantity provided would decrease, and price would increase

what is marginal analysis

considering the cost/benefit of the next unit produced or consumed

Marginal Private Cost (MPC)

the cost of the next unit produced or consumed

Marginal Private Benefit (MPB)

the benefit derived from the production or consumption of the next unit

in a production negative externalities diagram, which is higher, the MSC or MPC

MSC

on any externality diagram, what is the free market equilibrium

where MPC = MSB

what gap shows over-provision on negative externality cost diagram

gap between Q-opt and Q-e

how to find the welfare loss on a negative externalities cost of production diagram

the leftmost corner of the triangle is Q-opt•P-opt

then draw a vertical line up Q-e to where it hits MSC, that’s the long side of the triangle

examples of negative production externalities

• air pollution from factories

• damage to environment from industrial ocean fishing

• external costs of fertilisers and pesticides used in farming

• noise pollution from airline industry

examples of negative consumption externalities

• fly typing of household waste

• effects of passive smoking

• alcohol and gambling effects on family

• noise pollution from events like sports matches and concerts

private benefits

benefits received by producers or consumers directly involved in a transaction or economic activity

external benefits

benefits received by 3rd parties who aren’t part of the transaction or activity

social benefits

total benefits of an economic activity, both private and external

social benefits =

private benefit + external benefit

in a positive externality in consumption diagram, what would happen to the quantity consumed and prices of products if external benefits were considered

quantity consumed increases, sold at a higher price

in a consumption positive externalities diagram, which is higher, the MSB or MPB

MSB

what gap shows under-consumption on positive externality benefit diagram

gap between Q-e and Q-opt

how to find the welfare gain on a positive externalities benefit of consumption diagram

the rightmost corner of the triangle is Q-opt•P-opt

then draw a vertical line up Q-e to where it hits MSB, that’s the long side of the triangle

examples of positive production externalities

• flood defence projects benefit whole community

• projects to reduce deforestation

• apps that promote the ‘sharing’ of resources

• research and development, spillovers for other businesses

• bee-keeping, pollination

examples of positive consumption externalities

• healthcare/childcare/flue and other vaccines available to the public

• education/community work

• usage of mass transport services

impact of negative externalities on producers

producers may not fully account for external costs, leading to underproduction of goods with positive externalities

impact of negative externalities on consumers

consumers may not fully consider external costs, leading to underconsumption

impact of positive externalities on producers

producers may not capture all external benefits, leading to underproduction of goods with positive externalities

impact of positive externalities on consumers

consumers may not fully appreciate external benefits, leading to underconsumption

government intervention can correct negative externalities like

• taxes - internalise external costs, reducing overproduction

• subsidies - encourage greater provision of merit goods

• regulations - limit external costs or promote external benefits