2.1.2

Externalities

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Externalities

Externalities are the effects that producing or consuming goods have on other third parties or society as a whole. Buyers or producers do not consider externalities when making decisions. This can lead to market failure because goods or services can be under or over consumed.

Illustrative background for Positive consumption externalitiesIllustrative background for Positive consumption externalities ?? "content

Positive consumption externalities

  • This is a 'good' externality created in the consumption of a good.
  • The marginal social benefit is the total benefit of consuming a good or service to society. MSB = MPB + Externality.
  • If the consumption externality is positive, then the marginal social benefit is more than the marginal private benefit.
  • Consumers do not account for the benefit of the externality and this good will be under-consumed.
    • E.g. school education is a positive consumption externality because students become more productive for employers.
Illustrative background for Negative consumption externalitiesIllustrative background for Negative consumption externalities ?? "content

Negative consumption externalities

  • This is a 'bad' externality created in the consumption of goods/services (e.g cigarettes).
  • The marginal social benefit is the total benefit of consuming a good or service to society. It is equal to the marginal private benefit plus the value of the consumption externality.
  • If the consumption externality is negative, then the marginal social benefit is less than the marginal private benefit and the good will be overconsumed (vs the socially optimal level).
Illustrative background for Positive production externalitiesIllustrative background for Positive production externalities ?? "content

Positive production externalities

  • These are externalities incurred when producing a good or service.
  • Marginal social cost = Marginal private cost + Production externality. MSC is the total cost of producing a good or service to society.
  • If the production externality is positive, then the social cost is less than the private cost and the good will be underproduced.
Illustrative background for Negative production externalitiesIllustrative background for Negative production externalities ?? "content

Negative production externalities

  • These are externalities created when producing a good or service.
  • If the production externality is negative, then the social cost is greater than the private cost and the good will be overproduced (vs the socially optimal level).
    • E.g a factory producing noise and air pollution is likely to have a social cost larger than the private cost.

Costs and Benefits to Externalities

Externalities are created through an asymmetry of costs or benefits.

Illustrative background for Definition of costsIllustrative background for Definition of costs ?? "content

Definition of costs

  • Private cost:
    • The cost to an individual in the market.
  • External cost:
    • A cost put on a third party due to a negative externality.
  • Social cost:
    • The cost to society due to a negative externality.
    • Social cost = private cost + external cost.
Illustrative background for Definition of benefitsIllustrative background for Definition of benefits ?? "content

Definition of benefits

  • Private benefit:
    • The benefit to an individual in the market.
  • External benefit:
    • The benefit a third party receives due to a positive externality.
  • Social benefit:
    • The benefit to society due to a positive externality.
    • Social benefit = private benefit + external benefit.

Jump to other topics

1Introduction to Markets

2Market Failure

3The UK Macroeconomy

4The UK Economy - Policies

5Business Behaviour

6Market Structures

7A Global Perspective

8Finance & Inequality

9Examples of Global Policy

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