1.1.6 Externalities

Externalities are impacts on third parties due to the production/consumption of a good/service.

Negative externalities of production

External costs (negative externalities) exist when the social costs of an economic action are greater than the private costs. 

For example, a 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.

Private costs, external costs and social costs (Negative Externality of Production) 

With the example of the factory, we need to divide all the costs to society into private costs and external costs. The social cost of an activity is the total cost of that activity, both privately and externally. So:

SOCIAL COST = PRIVATE COSTS + EXTERNAL COSTS

Let us assume that our factory is making cars. The private costs to the factory owner will include things like wages, the cost of raw materials and rent. The external cost, or externality, is the cost to the third party of cleaning up the waste produced by the factory.

The total cost to society, therefore, must include the private cost, because society’s resources are being used in the production process, and the external cost, because some of society’s resources must be used to clear up the mess.

Positive externalities of consumption (merit goods)

So far we have been talking about negative externalities that arise from the production process – the classic textbook example. Positive externalities can occur when it comes to consumption. 

To illustrate this example, we need to look at private and social benefits:

SOCIAL BENEFIT = PRIVATE BENEFIT + EXTERNALITY

The reason why the formula uses the term ‘externality’ rather than ‘external benefit’ (the formula above had ‘external cost’) is because this externality can be positive as well as negative. 

Positive externalities

As I said earlier, although it is less obvious, there are examples of positive externalities. A good example is education. This includes 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.

Goods that create positive externalities of consumption are known as merit goods. 

Note: there are also demerit goods which create negative externalities of consumption. E.g. alcohol, drugs, sugar consumption etc. The IGCSE Edexcel specification focuses on negative externalities of production and positive externalities of consumption.