Module 7.2 Negative Externalities Lecture

Introduction to Externalities

• Definition: Externalities are costs or benefits that affect someone not directly involved in the consumption or production of a good.

• Types of Externalities: They can be negative or positive, impacting parties other than the consumers and producers.

Negative Externalities

• Definition: Negative externalities impose additional costs beyond those borne by the direct parties involved.

• Examples of Negative Externalities:

  • Pollution:

    • Usage of electricity benefits users (lights, AC, internet), but it also produces pollution, impacting the health of people near power plants.

    • Affected individuals do not receive compensation for health issues caused by pollution.

  • Antibiotic Usage:

    • Antibiotics improve health but can lead to antibiotic-resistant diseases that negatively affect others.

  • Loud Music:

    • A roommate's loud music benefits them while imposing a cost on others (e.g., inability to concentrate).

Private vs. Social Costs and Benefits

• Private Costs: The cost to the producer for producing a good (electricity, hamburgers, etc.).

• Private Benefits: The value received by the consumer, based on their willingness to pay.

• Social Costs: The total costs of producing a good, including external costs like pollution.

• Social Benefits: The total benefits derived from a good, including any external benefits.

Example: Roommate's Loud Music

• Demand for Loud Music:

  • Represents the roommate’s willingness to pay for each hour of music (marginal private benefit).

• Supply Curve:

  • Reflects the marginal private cost for each additional hour of music consumed.

• Consumption Decision:

  • Your roommate consumes music until their marginal private benefit equals marginal private cost (private equilibrium).

Marginal Social Cost and Equilibrium

• Marginal External Cost:

  • The impact of loud music on others (e.g., $6 discomfort per hour).

• Marginal Social Cost (MSC):

  • MSC = Marginal Private Cost + Marginal External Cost.

  • MSC is higher than the marginal private cost, reflecting the true cost to society.

• Social Equilibrium:

  • The optimal point occurs where marginal social cost equals marginal benefit, suggesting a lower consumption level (e.g., four hours of music).

• Deadweight Loss:

  • Represents the loss of surplus when overconsumption occurs, indicating that the marginal benefit from additional consumption is less than the marginal social cost.

Addressing Externalities

• Balancing Benefits and Costs:

  • The goal is not to eliminate the good or activity (like music or electricity) but to account for external costs in the consumption/production process.

  • Only externalities that impact parties outside the market lead to market inefficiencies.

Conclusion on Market Inefficiencies

• Market Dynamics:

  • Situations leading to higher prices (like taco demand) do not necessarily create externalities unless they impose additional costs on non-parties.

  • Markets can efficiently operate when prices reflect all costs, including externalities.

• Importance of Accounting for External Costs:

  • Recognizing the existence of external costs is essential for achieving socially efficient outcomes.