Lecture 9

Externalities
Consider this
• A chemical plant dumps waste into
a river to minimize costs.
• Further down the river, a water
company treats the water to remove
dangerous chemicals before
supplying drinking water to
consumers.
• Because of pollution, consumers
now pay higher prices for water.
Externalities
• The effect – of having to pay more for water – is what we refer to as
externalities.
• Externalities are spillover effects, or third-party effects, and can be
either positive or negative.
• Unfortunately, the decisions and transactions made in the market by
producers and consumers, do not account for externalities or effects to
society.
• Where effects are undesirable, we refer to as negative externalities.
• Where effects are desirable, we refer to as positive externalities.
Private cost vs social cost –
producer vs society
• To understand how these externalities are derived, we compare two costs:
private costs, and social costs.
• Private costs are costs of activities to individual economic units i.e.
individuals, firms.
• Social costs are costs of activities not just to individual economic units, but
also to the rest of society. Social costs include private costs.
• Think of social cost like ‘a price society has to pay’.
• So, consumers having to pay higher prices for water is considered a social
cost. In this case, the social cost is greater than the private cost.
• The chemical plant is producing at a cost that does not account for cost of
effects to society.
Private cost vs social cost –
producer vs society
• Where social costs are greater than private costs, there exists
negative externalities. So, in the case of the chemical plant –
negative externalities of production.
• Where private costs are greater than social costs, there exists
positive externalities of production.
Private cost vs social cost –
producer vs society
• An example of positive
externalities of production – a
supermarket decides to redevelop a
derelict industrial site for a new
store, but at the same time cleans
up pollution on site, improves
roads on site, and subsidizes
construction of some social
housing next to the new store.
• The supermarket’s private costs are
greater than social costs.
Private benefit vs social benefit –
consumer vs society
• On the consumer side, there are also positive and negative externalities
as a result of consumers’ buying decisions.
• While on the producer side, there are social costs and private costs, on
the consumer side, we are looking at private benefits and social
benefits.
• Private benefits benefit the individual or firm.
• Social benefits benefit not just the individual or firm, but also to the
rest of society.
Private benefit vs social benefit –
consumer vs society
• Where social benefits are greater than private benefits, there exists
positive externalities of consumption.
• E.g. when a child is immunized against chickenpox, the likelihood of
an unimmunized child in the local area to contract chickenpox is less.
• Where private benefits are greater than social benefits, there exists
negative externalities of consumption.
• E.g. a person who smokes harms the health of others in the same
room.
Externalities cause Market Failure
Externalities cause market failure
• One of the key reasons why markets fail is because externalities exist.
• We say market failure when the free market (or market mechanism)
fails to allocate resources at a socially optimal level.
• This leads to a loss in social welfare.
• Let’s see how these are illustrated using the demand and supply
curves.
Externalities cause market failure
• And to help us illustrate, we are going to use these steps:
• 1, What curve moves? Demand or supply?
Supply: production – firms – costs;
Demand: consumption – consumers – benefits
• 2, Which way does it move? Negative = left, Positive = right
• 3, Curve that moved is the social curve
• 4, Market equilibrium takes private effects into account
• 5, Social equilibrium considers full social effects
• 6, Welfare loss – compare MSC and MSB at market equilibrium
Externalities cause market failure
• Quick note: MSC is marginal social cost, MSB is marginal social benefit.
• The word ‘marginal’ simply refers to every additional unit of output
produced / consumed.
• So, when we say marginal cost of production, it means the extra cost of
producing an extra unit of output. This affects the supply side of things.
• With marginal benefit, it means the benefit received from consuming an
extra unit of output. This affects the consumer side of things.
• If we want a society that enjoys maximized welfare, the socially optimal (or
ideal) output / quantity is where social cost meets social benefit.
Negative Externalities in Consumption
Negative externalities in consumption
• Let’s first look at negative
externalities in consumption, or
third-party/spillover negative
effects caused by consumers
buying decisions.
• 1, Consumption – consumers –
demand curve – benefits.
• 2, Negative externalities, so left
shift of demand curve.
• 3, New demand curve is the
social curve.
Negative externalities in consumption
• 4, Market equilibrium (where
MPB meets MPC) only considers
private effects – private benefits
and private costs.
• 5, Social equilibrium (where
MSB meets MSC) takes into
account for social effects – social
benefits and social costs.
Negative externalities in consumption
• 6, Welfare loss, or deadweight
loss, or how much society is
being harmed by a misallocation
of resources – we compare MSC
and MSB.
Negative externalities in consumption
• As you see, marginal private
benefit (MPB) is greater than
marginal social benefit (MSB).
• This means that consumers’
buying decisions are ultimately
in their own self-interest, thus do
not care that much about benefits
that their decisions would accrue
to society.
Negative externalities in consumption
• Point B is the quantity that society
would like to have consumed, but does
not happen.
• Point A is the quantity that consumers
actually consumed.
• So, there is overconsumption (B>A).
• This means that there has been a
misallocation of resources (that leads
to overconsumption), and there exists
market failure.
• Take the example on passive smoking.
Negative externalities in consumption
• A person who smokes only cares
about his/her self-interest, but
does not realize that his/her
smoking does not take into
account for effects onto society
(passive smokers) – this is where
marginal private benefit (MPB)
is greater than marginal social
benefit (MSB).
• So, when we compare the social
cost and the social benefit i.e.
MSC and MSB, if MSC > MSB,
there is welfare loss.
Negative Externalities in Production
Negative externalities in production
• Now, let’s look at negative
externalities in production, or
third-party negative effects
caused by producers.
• 1, Production – producers –
supply curve – costs.
• 2, Negative externalities, so left
shift of supply curve.
• 3, New supply curve is the social
curve.
Negative externalities in production
• 4, Market equilibrium (where
MPB meets MPC) only considers
private effects – private benefits
and private costs.
• 5, Social equilibrium (where
MSB meets MSC) take into
account for social effects – social
benefits and social costs.
Negative externalities in production
• 6, Welfare loss, or deadweight
loss, or how much society is
being harmed by a misallocation
of resources – we compare MSC
and MSB.
Negative externalities in production
• So, here, marginal social cost
(MSC) is greater than marginal
private cost (MPC).
• This means that in the production
of goods, producers care for their
own self-interest, thus do not
care much about the costs that
would be incurred by society.
Negative externalities in production
• Point B is the quantity that society
would like to have produced, but
does not happen.
• Point A is the quantity that
producers actually produced.
• So, there is overproduction (A>B).
• This means that there has been a
misallocation of resources (that
leads to overproduction), and there
exists market failure – to be specific
– partial market failure.
Negative externalities in production
• Take the example of the chemical plant dumping waste into the river.
• The chemical plant dumps waste in order to minimize costs. And the
water company has to treat these waste water in order to supply clean
water for consumption. These ultimately affect the consumers/society
who now have to pay higher prices. This is where marginal social cost
(MSC) is greater than marginal private cost (MPC).
Negative externalities in production
• So, when we compare the social cost and the social benefit i.e. MSC
and MSB, if MSC > MSB, there is welfare loss.
• Another example – in Brazil, it makes sense to clear some forest to
create grazing land for cattle sold to the West for as meat for
hamburgers. But this may lead to economic catastrophe in the long
term because of global warming. The market is putting out the wrong
signals, leading to a misallocation of resources.
Positive Externalities in Consumption
Positive externalities in consumption
• Now, let’s turn to positive
externalities in consumption, or
third-party positive effects
caused by consumers.
• 1, Consumption – consumers –
demand curve – benefits.
• 2, Positive externalities, so
right shift of demand curve.
• 3, New demand curve is the
social curve.
Positive externalities in consumption
• 4, Market equilibrium (where
MPB meets MPC) only considers
private effects – private benefits
and private costs.
• 5, Social equilibrium (where
MSB meets MSC) takes into
account for social effects – social
benefits and social costs.
Positive externalities in consumption
• 6, Welfare loss, or deadweight
loss, or how much society is
being harmed by a misallocation
of resources – we compare MSC
and MSB.
Positive externalities in consumption
• So, here, marginal social benefit
(SB) is greater than marginal
private benefit (PB).
• This means that consumers do
not realize that their buying
decisions do not take into
account benefits that could
accrue to society. Consumers
undervalue the good.
Positive externalities in consumption
• Point B is the quantity that society
would like to have consumed, but does
not happen.
• Point A is the quantity that consumers
actually consumed.
• So, there is underconsumption
(A<B).
• This means that there has been a
misallocation of resources (that leads
to underconsumption), and there exists
market failure.
• Take the example on immunization or
education/training.
Positive externalities in consumption
• A child may benefit from immunization against illnesses – self-benefit
– and this indirectly has a positive effect on society, because other
unimmunized children in the local area are less likely to contract the
illness.
• Or, if an individual receives training or education – self-benefit – this
indirectly has a positive effect on society because other companies
could now poach the individual.
Positive externalities in consumption
• These are where marginal social benefit (MSB) is greater than
marginal private benefit (MPB).
• So, when we compare the social cost and the social benefit i.e. MSC
and MSB, if MSC > MSB, there is welfare loss – or shall we say, the
welfare gain that could have otherwise achieved.
Positive Externalities in Production
Positive externalities in production
• Finally, let’s look at positive
externalities in production, or
third-party positive effects
caused by producers.
• 1, Production – producers –
supply curve – costs.
• 2, Positive externalities, so
right shift of supply curve.
• 3, New supply curve is the social
curve.
Positive externalities in production
• 4, Market equilibrium (where
MPB meets MPC) only considers
private effects – private benefits
and private costs.
• 5, Social equilibrium (where
MSB meets MSC) take into
account for social effects – social
benefits and social costs.
Positive externalities in production
• 6, Welfare loss, or deadweight
loss, or how much society is
being harmed by a misallocation
of resources – we compare MSC
and MSB.
Positive externalities in production
• So, here, marginal private cost
(MPC) is greater than marginal
social cost (MSC).
• This means that in the production
of goods, producers care not just
for their own self-interest, but
also care about the costs that
society would have to incur, but
these society costs are
“absorbed” by the producers.
Positive externalities in production
• Point B is the quantity that society
would like to have produced, but
does not happen.
• Point A is the quantity that
producers actually produced.
• So, there is underproduction
(A<B).
• This means that there has been a
misallocation of resources (that
leads to underproduction), and there
exists market failure – to be specific
– partial market failure.
Positive externalities in production
• Take the example of the supermarket.
• The supermarket owners could have just developed their new store on
a piece of derelict land, and ignore the costs that the development may
bring to society, but decided to clean up pollution on site, improve the
roads around site, and subsidize construction of some social housing.
These are costs that society would have incurred were it not for the
supermarket owners’ decisions.
• This is where the marginal private cost (MPC) is higher than marginal
social cost (MSC).
Summary
• Externalities are benefits or costs that affect third parties (society) who
did not in the first place choose to receive that benefit or cost.
• These third parties had not been part of the market transactions that
take place between producers and consumers.
Exercise – Textbook Page 114, Q2
• According to the NHS, passive smoking is harmful to the health of
non-smokers. Second-hand smoke ‘contains more than 4,000
chemicals, many of which are irritants and toxins, and some of which
are known to cause cancer’. Children who are subject to passive
smoking are more likely to suffer a cot death, develop asthma and
other serious respiratory conditions, or have coughs and colds.
Children who grow up with a parent or family member who smokes
are three times as likely to start smoking themselves.
Source adapted from www.nhs.uk.
• (a) Why might smoking lead to the creation of externalities?
• (b) Using a supply and demand diagram, explain how smoking causes
market failure.
Exercise – Textbook Page 117, Q3
• In 2014 media sources reported that tap water was cut off for the day in the
Chinese city of Jingjiang. It followed detection of an unknown pollutant in the
city’s water supplies. Jingjiang, a city on the river Yangtze, is a centre for
shipbuilding and textiles, and it was thought that either industry could have been
the source of the pollution. Photos posted online showed residents filling
buckets from an emergency reservoir in a local public park.
• China is investing $536 billion in wastewater treatment and purification plants
during the five years to 2015, but one quarter of its citizens still do not have
access to clean drinking water.
Source adapted from © The Financial Times 10.5.2014, All Rights Reserved.
• (a) Explain how the shipbuilding or textile industry in Jingjiang may have
created an externality.
• (b) Using a diagram, explain why there has been a misallocation of resources.
Readings and assignment
• Essential – please read Unit 21 of textbook.
• Anderton, Alain. (2015). Unit 21: Externalities. In Economics (6th ed.), pp.113-
119. UK: Anderton Press Ltd.
• Assignment
• Please attempt the unit questions in the textbook.