Unit 8: Common Pool Resources and Externalities

Externality

A cost or benefit that falls on a third party not involved in the market transaction — a spillover effect not reflected in the market price.

Negative Externality of Production

A cost imposed on third parties by the production of a good. MSC > MPC; the good is overproduced relative to the social optimum.

Positive Externality of Production

A benefit conferred on third parties by the production of a good. MSC < MPC.

Negative Externality of Consumption

A cost imposed on third parties by the consumption of a good. MSB < MPB; the good is overconsumed relative to the social optimum.

Positive Externality of Consumption

A benefit conferred on third parties by the consumption of a good. MSB > MPB; the good is underconsumed relative to the social optimum.

Marginal Private Cost (MPC)

The cost borne solely by the producer of one additional unit of output, excluding external costs.

Marginal External Cost (MEC)

The additional cost imposed on third parties from the production or consumption of one more unit.

Marginal Social Cost (MSC)

The total cost to society of producing one additional unit. MSC = MPC + MEC.

Marginal Private Benefit (MPB)

The additional benefit received solely by the individual consumer from one more unit.

Marginal External Benefit (MEB)

The additional benefit conferred on third parties from the production or consumption of one more unit.

Marginal Social Benefit (MSB)

The total benefit to society from consuming one additional unit. MSB = MPB + MEB.

Social Optimum

The output level at which MSB = MSC. This maximises social welfare.

Market Optimum

The output level determined by the free market where MPB = MPC. Diverges from the social optimum when externalities exist.

Demerit Good

A good overconsumed relative to the social optimum because consumers underestimate its negative effects or fail to account for negative externalities.

Merit Good

A good underconsumed relative to the social optimum because positive externalities or imperfect information lead to underprovision.

Pigouvian Tax

A tax set equal to the MEC of production, internalising the negative externality by shifting the supply curve leftward to the social optimum.

Pigouvian Subsidy

A subsidy equal to the MEB of consumption, shifting demand or supply rightward to the social optimum.

Tradeable Emission Permits (Cap and Trade)

The government sets a cap on total pollution, distributes permits to firms, and allows trading. Firms with low abatement costs sell permits to those with high costs.

Common Pool Resource

A resource that is non-excludable and rivalrous. One person's use reduces availability to others and it is difficult to prevent access.

Tragedy of the Commons

The tendency for common pool resources to be overexploited because each individual ignores the full social cost their use imposes on others.

[HL] Welfare Loss — Negative Externality

The deadweight loss triangle between Qm and Qopt, bounded by MSC above and MPB below. Represents the net cost of overproduction to society.

[HL] Welfare Loss — Positive Externality

The deadweight loss triangle between Qm and Qopt, bounded by MSB above and MPB below. Represents the net loss from underconsumption.