1.3.2 Externalities Flashcards
Externalities
The effects that producing or consuming a good/service has on third parties.
What are positive externalities?
The external benefits to society.
What are negative externalities?
The external costs to society.
Example of positive externality of production
Bees pollinating plants
Example of negative externality of production
Pollution from burning of fossil fuels
Example of positive externality of consumption
Vaccines
Example of negative externality of consumption
Litter
Social cost
A cost experienced by a 3rd party as a result of the consumption of a product or service by another individual.
Private cost
A cost experienced by the individual/firm that has consumed the product or service.
Social benefit
A benefit experienced by a 3rd party as a result of the consumption of a good/service by another individual.
Private benefit
A benefit experienced by the individual/firm that has consumed the good/service.
Example exernalities diagram
Key labels on the externalities diagram
MPC = Marginal Private Cost
MSC = Marginal Social Cost
MPB = Marginal Private Benefit
MSB = Marginal Social Benefit
Qe = Quantity equilibrium
Equilibrium Point on the Externalities Diagram
When supply and demand are equal, there is an equilibrium point in the free market.
In a free market, consumers and products only consider their private costs and private benefits – they ignore any social costs or benefits. As a result, the MPC curve can be seen as the supply curve of a good/service and the MPB curve can be seen as the demand curve.
So equilibrium occurs when MPC = MPB.
Where is the socially optimum level of output on an externalities diagram?
The socially optimum level of output is where MSC = MSB.
Negative externalities of production diagram
In this diagram, the optimal output level of this good is Q1 and the optimal price is P1. As there are no positive externalities, MPB = MSB.
However, in the free market only private costs are considered. So output would be Qe and the price out be Pe.
This would cause overproduction and under-pricing of this good – more is produced and sold at a lower price than is desirable for society. For each unit of this good produced between Q1 and Qe the marginal social cost is greater than the marginal social benefit.
The area between the MSB and MSC is shown by the yellow triangle ABC. This is the area of welfare loss – the loss to society caused by ignoring externalities.
Positive externalities of production diagram
In this diagram, the optimal output level of this good is Q1 and the optimal price is P1 (assuming MPB = MSB). The marginal private cost is larger than the marginal social cost.
In the free market only private benefits are considered. So output would be Qe and the price out be Pe.
This would cause underconsumption and over-pricing of this good – less is produced and sold at a higher price than is desirable for society. For each unit of this good produced between Qe and Q1 the marginal social cost is lower than the marginal social benefit.
The area between the MSC and MSB is shown by the green triangle PQR. This is the area of potential welfare gain – the gain to society that is lost by ignoring externalities.
Positive externalities of consumption diagram
In this diagram, the optimal output level of this good is Q1 and the optimal price is P1. As there are no negative externalities, MPB = MSC.
In the free market only private benefits are considered. So output would be Qe and the price out be Pe.
This would cause underconsumption and under-pricing of this good – less is consumed and sold at a lower price than is desirable for society. For each unit of this good produced between Qe and Q1 the marginal social benefit is lower than the marginal social cost.
The area between the MSB and MSC is shown by the green triangle DEF. This is the area of potential welfare gain – the gain to society that is lost by ignoring externalities.
Negative externalities of consumption diagram
In this diagram, the optimal output level of this good is Q1 and the optimal price is P1 (assuming MPC = MSC). The marginal private benefit is larger than the marginal social benefit.
In the free market only private benefits are considered. So output would be Qe and the price out be Pe.
This would cause overconsumption and over-pricing of this good – more is consumed and sold at a higher price than is desirable for society. For each unit of this good produced between Qe and Q1 the marginal social cost is greater than the marginal social benefit.
The area between the MSC and MSB is shown by the yellow triangle KLM. This is the area of welfare loss – the loss to society caused by ignoring externalities.
