Externalities

Keywords: 

 

Qopt (socially optimum output) 

Marginal costs: The extra cost of producing one more unit of output. (Like farmers having to buy seeds and pay workers to work on the land). Marginal cost increases as the unit of output increases. (Meaning farmers can only produce more output if the price of the good increases, to cover the extra cost of each extra unit produced).  

 

Marginal benefits: The extra benefit that consumers get from each additional unit of something they purchase (like buying milk over and over again; the more you drink the less benefit you get from the previous one). 

  • How does the demand curve relate to marginal benefit? 

 

Demand is how much consumers are willing and able to buy a good at certain prices over a certain period. But it can also be thought of as showing the amount of money that the consumers are willing to pay to get one more unit of the good. Since the marginal benefit that the consumers get from buying one more unit of a good gets smaller and smaller as the quantity increases, this means the price the consumers is willing to pay also gets smaller and smaller as the number of units bought increases. 

 

socially optimal (or social optimum) refers to a situation where resources are allocated in a way that maximises total welfare for society as a whole.

 A negative externality ALWAYS produces too much (overallocation of resources), while a positive externality ALWAYS produces too little (underallocation of resources).

  • So for positive externality, the quantity of the free market (Qm) is less than the social optimal quantity (Qopt)

  • If the free market quantity (Qm) is producing more than the social optimal, we are producing too much, meaning a negative externality.

MSB = MSC at Qsopt!!!!

  • When MB>MC, it means the benefit of an additional action is outweighing its cost (like if a factory is producing chairs and selling one more chair earns the company $50 in revenue (MB), and the cost of producing one more chair (materials, labor, etc.) is $30 (MC), the factory should produce more chairs because it is profitable).  

  • When MC>MB, it means the extra cost of an activity is higher than the extra benefit gained from it, and it’s better to stop or reduce the activity because it results in a loss or inefficiency. (Like if a factory is producing chairs. The chair sells for $40 (MB), but the cost of producing the chair is $30 (MC). Since the MC>MB, the factory loses $10 on every extra chair. It should stop producing at this level or find ways to lower costs).  

 

 

 

 

 

 

What is an externality? 

An externality is the cost incurred, or the benefit received by a third party, whereas the third party has no control over the costs or benefits. 

If the side effects on the third party include benefits, then it’s a positive externality, but if it involves costs in the form of a negative side effect, then it is a negative externality. 

 

  • What is marginal private benefit? 

The additional benefit received by an individual consumer or producer from consuming or producing one more unit of a good or service. (If you buy a cup of coffee, the enjoyment you get from drinking it is the MPB, because it’s personal and doesn’t account for effects on others). 

 

  • What is marginal social benefit? 

The additional benefit to society from consuming or producing one more unit of a good or service. (If you get vaccinated, the protection you get is the MPB, but society also benefits because you’re less likely to spread the disease. It’s affecting society as a whole; benefiting it).  

 

 

 

  • MPC is the cost to producers of producing one more unit of a good. 

  • MSC is the cost to society of producing one more unit of a good. 

  • MPB is the benefits to consumers from consuming one more unit of a good. 

  • MSB is the benefits to society from consuming one more unit of a good.