EXTERNALITIES

What is a private cost?

The cost of production borne by the producer of a good or service.

What is an external cost?

A cost imposed on third parties not involved in the transaction, e.g., pollution affecting nearby residents.

What is a social cost?

The total cost to society of producing a good, including both private costs and external costs.

Social cost = Private cost + External cost

What is a private benefit?

The benefit received by the consumer or producer directly involved in a transaction.

What is an external benefit?

A benefit received by a third party not directly involved in the transaction, e.g., vaccination reducing disease in the community.

What is a social benefit?

The total benefit to society of consuming or producing a good, including private and external benefits.

Social benefit = Private benefit + External benefit

What is a negative externality of production?

A situation where producing a good imposes costs on third parties, e.g., factory pollution.

How is a negative production externality shown on a diagram?

1. Curve Construction
   • Draw the private marginal cost (PMC) curve.
   • Draw the social marginal cost (SMC) curve above PMC, showing external costs.
2. Equilibrium Points
   • Market equilibrium is where PMC = \text{demand}.
   • Socially optimal output is where SMC = \text{demand}.
3. Welfare Loss
   • The area between SMC and PMC overproduced output shows welfare loss.

What is the welfare loss due to negative production externalities?

It is the reduction in total social welfare caused by overproduction at market equilibrium relative to the socially optimal level.

What is a positive externality of consumption?

A situation where consuming a good provides benefits to third parties, e.g., education or immunisation.

How is a positive consumption externality shown on a diagram?

1. Curve Construction
   • Draw private marginal benefit (PMB) curve.
   • Draw social marginal benefit (SMB) curve above PMB, showing external benefits.
2. Equilibrium Points
   • Market equilibrium is where PMB = \text{supply}.
   • Socially optimal consumption is where SMB = \text{supply}.
3. Welfare Gain
   • The area between SMB and PMB over under-consumed output shows welfare gain if corrected.

What is the distinction between market equilibrium and social optimum?

1. Equilibrium Definitions
   • Market equilibrium: quantity where private cost = private benefit.
   • Social optimum: quantity where social cost = social benefit.
2. Market Failure
   • Externalities cause market failure, meaning market equilibrium \neq social optimum.

How do externalities affect economic agents?

1. Producers: May ignore external costs (overproduction).
2. Consumers: May ignore external benefits (underconsumption).
3. Third parties: Bear costs or miss out on benefits.
4. Government: May intervene to correct market failure.

What are common government interventions for negative production externalities?

• Taxes on producers (e.g., Pigovian tax) to internalise external costs.
• Regulation (limits or standards).
• Tradable permits for pollution.

What are common government interventions for positive consumption externalities?

• Subsidies to encourage consumption.
• Provision of public goods or free services.
• Legislation to encourage uptake (e.g., vaccination campaigns).

Why does a negative production externality cause overproduction?

Because private costs are lower than social costs (PMC < SMC), so the market produces more than the socially optimal quantity.

Why does a positive consumption externality cause underconsumption?

Because private benefits are lower than social benefits (PMB < SMB), so the market consumes less than the socially optimal quantity.

How is welfare loss/gain represented on a diagram?

• Negative externality: welfare loss triangle between SMC and PMC above market quantity.
• Positive externality: welfare gain triangle between SMB and PMB above market quantity.

How can a subsidy correct a positive consumption externality?

By lowering the effective price for consumers, increasing consumption toward the social optimum by effectively shifting the PMB upward.

How can a tax correct a negative production externality?

By increasing the cost of production, reducing output toward the social optimum by effectively shifting the PMC upward.

What is "internalising the externality"?

Adjusting market incentives (via tax, subisdy, or regulation) so that private costs/benefits reflect social costs/benefits.

How do externalities link to market failure?

They lead to overproduction or underconsumption relative to the social optimum, causing allocative inefficiency.

Can you give a real-world example of a negative production externality?

Industrial pollution causing health problems for nearby residents.

Can you give a real-world example of a positive consumption externality?

Immunisation reduces disease spread, benefiting unvaccinated people.

How do diagrams show the impact of government intervention?

1. Tax Integration
   • Tax shifts PMC upward \to market output closer to SMC.
2. Subsidy Integration
   • Subsidy shifts PMB upward \to market output closer to SMB.
3. Outcome
   • Welfare loss or gain is reduced.