Externalities

Economics: Edexcel A A Level, topic 2.1.2

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.

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.

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).

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.

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.

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.

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.

Test yourself on Externalities

What does this externality diagram show?
What does this externality diagram show?
What does this externality diagram show?
"The cost to an individual in the market"
What type of cost is this?

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