1.3.2 Externalities (Micro)

Externalities definition

The unintended positive or negative side effects of producing or consuming goods to a third party, who’s not involved in the transaction.

Positive Externality

When consuming or producing a good causes a benefit to the third party.

Impact of positive Externalities

• Producers may not capture all external benefits, leading to underproduction of goods with positive externalities.

• Consumers may not fully appreciate external benefits, leading to under consumption.

• Overall, positive externalities can result in under allocation of resources to beneficial activities.

Negative Externality

When consuming or producing a good causes a cost to the third party

Impact of Negative Externalities

• Producers may not fully account for external costs, leading to overproduction of goods with negative externalities.

• Consumers may not fully consider external costs, leading to overconsumption.

• Overall, negative externalities can result in market inefficiencies and reduced social welfare.

Mixed Externality

Occur when production and/or consumption leads to both external costs and external benefits.

Benefits of Government Intervention on Externalities

• The government can correct externalities through using taxes, subsidies, and rules.

• Taxes on harmful activities make producers reduce them.

• Subsidies encourage more of helpful goods and services.

Why are Externalities Inevitable

• Interconnected economy:
  People, firms, and governments affect each other —> so actions can have wider effects (e.g. pollution affecting others).

• Property rights and transaction costs:
  Ownership isn’t always clear and making agreements can be difficult and costly.

• Public goods:
  Things like clean air benefit everyone. People may not pay for them, so they are often underprovided.

How does Externalities cause Market Failure

• They stop markets working efficiently.

• Market failure happens when resources are not allocated efficiently, leading to a loss of social welfare.

• This occurs because market prices and output do not include external costs or benefits.

Marginal Private Cost (MPC)

Is the internal cost to a producer or consumer from supplying or consuming one extra unit of a good or service.

Marginal Private Benefit (MPB)

Is the extra benefit, satisfaction or utility gained by a consumer or producer through consuming or producing one extra unit of a good or service.

Marginal External Cost

Cost to third parties from the production/ consumption of an extra unit of output.

Marginal External Benefit

External benefits are benefits received by third parties who are not part of the transaction or activity, often beneficial to society.

Marginal Social Cost

Total cost to society arising from producing/ consuming an extra unit of output. MSC= MPC + MEC

Marginal Social Benefit

Social benefits represent the overall positive impact that they have on an society.

Marginal Private Cost

Private costs are the costs that the people or businesses involved in buying or producing something have to pay themselves.

Marginal Private Benefit

Private benefits are the benefits people get from something they buy or produce themselves.

Negative Externalities from Production Examples

• Air pollution form factories

• Pollution from fertilizers

• Industrial waste

• Noise pollution

Negative Externalities from Consumption Examples

• Household waste

• Traffic congestion

• Litter/ waste

• Particulate from vehicle pollution