1.1.6 Externalities

Externality

Impacts on third parties due to the production/consumption of a good/service - can be positive or negative

Negative externality

when one party, such as a business, makes another party worse off, yet does not bear the costs from doing so.

Example of negative externality

POLUTION - chemical manufacturer located on the banks of a river will incur a number of private costs of production (for example, raw materials, labour and running machinery) but may also impose costs on third parties, such as noise from delivery lorries, an ugly car factory affecting the quality of life of local residents and pollution in the form of chemicals being pumped into the river.

Negative externality equation

SOCIAL COST = PRIVATE COSTS + EXTERNAL COSTS

Positive externality

When one party, such as a business, makes another party better off but does not receive any compensation for doing so.

Positive externality formula

SOCIAL BENEFIT = PRIVATE BENEFIT + EXTERNALITY

Example of positive externality

EDUCATION - Training by firms as well as what goes on in schools and universities. If you get a good education, there are obvious private benefits; better career prospects and higher future earnings for instance. But there are external benefits as well. The obvious economic one is that a better educated workforce is a more productive and efficient one, but there is also the fact that well educated people are less likely to resort to crime. This is almost like an avoidance of a negative externality.

What is a merit good?

Goods that create positive externalities of consumption