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A spillover cost or benefit that accrues from
the consumption or production of a good.
An externality is an effect on others who did
not have a choice and whose interests were
not taken into account when a good was
produced or consumed.
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To examine externalities we need to do a COST-BENEFIT analysis of
the market. This means thinking about demand as the marginal benefit
gained by consumers of a product. It will be expressed by their
willingness to pay for a product. Supply, on the other hand, is derived
from the marginal cost of production and is the price.
The vertical axis is now measuring MB and MC
MB/MC
Price
Supply
Marginal Cost
Marginal Benefit
Demand
Quantity
MB and MC only include the
private benefits and costs
that come from consuming
or producing a product.
Equilibrium price and
quantity are the private
equilibrium only.
Any externality adds a social
cost or social benefit to
these curves.
Negative Externalities…
A cost that is borne by the community over and above the private
costs that accrue to the consumers and producers directly involved in
the transaction.
…from Production
Examples would include air, water,
noise, visual or other pollution that is
created as a good is produced.
more details
…from Consumption
Examples would include pollution that
comes from consuming a good (passive
smoking) or harmful behaviours (drunken
brawls).
more details
Positive Externalities…
A benefit to the community over and above the private benefits that
accrue to the consumers and producers directly involved in the
transaction.
…from Production
Examples would include the
recreational possibilities of a hydrodam or commercial forest.
more details
…from Consumption
Examples would include the benefits
to be had from public transport use or
vaccination programmes.
more details
Negative Externalities
back
Take for example the market for paper from a mill beside a river. Large
amounts of water to wash the pulp are taken from the river. In a free
market the cheapest
(profit maximising option) would be to release
from Production
this water, loaded with chemicals, back into the river.
MB/MC
Paper Market
The private
social costs
(free of
market)
releasing
polluted water
equilibrium
position
may include
is shown
the
loss
as
Peof:
, Qe• fish and plant life
• a recreational area
• drinking water
MSC
MC
Ps
social
subsidy
Pe
MB
Qs
Qe
Quantity
Society
Effectively,
If
these would
costs
society
were
rather
is
added
pay more
to
subsidising
the
for
paper
cost curve,
and
this
have
then
producer
less
the by
not holding
Marginal
produced
Social
because
themCost
accountable
of curve
this
for their
would
negative
bepollution.
externality.
higher.
And a subsidy creates a
deadweight loss.
Negative Externalities
back
Take the
When
considering
social cost
externalities
of second-hand
of consumption,
smoke that results
the marginal
from cigarette
cost is a
constant as
smoking.
Non-smokers
individual consumers
are at risk of
cannot
developing
influence
cancers
the market
or suffering
price of
a product.
in
other ways.
from
Consumption
The private
When
we add
(free
in the
market)
social
equilibrium
costs,
they are
position
almost
is nonshown
as Pe, Qeat low levels of
existent
Cigarettes
MB/MC
consumption, but accelerate as
smoking rates increase. The
MSC
Marginal Social Cost curve
would look like this.
So society would rather pay
social
more and see less tobacco
Ps
subsidy
consumed.
In a free market, society would
Pe
MC
be subsidising smokers by not
MB
holding them accountable for
the harm they do others.
Qe
Qs
Quantity And, of course, there is a
deadweight loss.
back
The production process can sometimes produce positive spillovers for
society. Hydro dams create large lakes that provide a range of
recreational and sporting opportunities for the wider community (eg
Lake Karapiro).
The free market equilibrium (Pe Qe)
does not include these positive
Hydro-Electicity
MB/MC
externalities.
To provide equivalent facilities
MC
MSC
would cost a great deal, so the
hydro firm could be said to be
reducing costs for society. The
Pe
Marginal Social Cost curve
would be lower that the private
MC curve.
Positive Externalities
from Production
Society would like a greater
number of hydro lakes, and
there is a deadweight loss if they
Quantityare not provided.
MB
Qe
Q
s
back
Vaccination programmes provide benefits beyond those who receive
the jabs. The virtual elimination of polio, small pox and other diseases
has allowed people to live longer, healthier and more productive lives.
Yet developing vaccines has a high cost and the public doesn’t
necessarily appreciate their benefit. The free market equilibrium
position is Pe, Qe
Polio Vaccination
MB/MC
When the positive externalities
are included, the MSB curve
will be to the right of the MB
curve.
Society’s preference is for
greater levels of vaccination
Pe
MC
than would happen in a free
market.
from Consumption
And, of course, there is the
deadweight loss if that
MSB
MB
preference is not met.
Positive Externalities
Q
Q
e
e
Quantity
the
The goal is to remove the deadweight loss by getting
private costs and benefits to shift to the same
equilibrium point as the social costs and benefits.
In particular,what
society
canisbe
concerned
done about
about
themreaching the
socially desirable quantity of the good in question.
Negative Externalities
How can we get the polluter to
incorporate these external costs into
their (internal) production costs?
from Production
This means moving the MC curve to equal the MSC curve.
The policy options for the government include:
• Taxing polluters
• Regulating emissions
MB/MC
Paper Market
With either policy the aim is to
remove the deadweight loss that
occurs in the free market by
shifting to the socially optimum
level of output (Qs).
MSC
MC
Pe
MB
Qs
Qe
Quantity
Regulating
A
tax, if it isemissions
set correctly,
would
will
shift thepollution,
reduce
MC upward.
andAfirms
tax,
would
be doesn’t
requiredprevent
to meet the
however,
pollution.
cost
of anti-pollution measures.
The effect on the graph, though,
would look the same.
Negative Externalities
from Consumption
Society wants less people to smoke.
But if people will still smoke, how can we get smokers to pay for the
harm their smoking does to others?
The goal is to reduce consumption to Qs. Policy options include:
• Taxing smokers
• Regulating sales
MB/MC
• Education
Cigarettes
Regulations
A
tax will raise
can
the
beMC
imposed
curve,
reducing consumption
restricting
access, or making
towards
it
the desired
harder
to smoke.
level. Such measures
would reduce demand (the MB
curve), achieving the same
result as a tax.
MSC
Pe
MC
MB
Qs
Qe
An education initiative (ad
campaigns, warning on packs,
etc) would also reduce demand.
Quantity
Positive Externalities
from Production
MB/MC
If hydro lakes are such good community
resources, how do you get the power
companies to build one near you?
Hydro-Electicity
MC
MSC
Pe
MB
Qe
Q
s
Quantity
Positive Externalities
from Consumption
All in society gain if more people are
vaccinated.
But some object to vaccination, some are not aware of the benefits,
some cannot afford it, or simply wont bother. How do we raise
‘consumption levels’?
Polio Vaccination
MB/MC
Pe
MC
MSB
MB
Q
Q
e
e
Quantity