Group 18

Assignment-1 | Session 19

Externalities
An externality is a cost or gain that an unrelated third-party bears as a result of an
economic activity. The final cost or benefit of a good or service does not include the
external cost or benefit. As a result, economists often regard externalities as a severe issue
that causes markets to become inefficient, resulting in market failures.
The primary cause of externalities is poorly defined property rights. The ambiguous
ownership of certain things may create a situation when some market agents start to
consume or produce more while the part of the cost or benefit is inherited or received by
an unrelated party. Environmental items, including air, water, and wildlife, are the most
common examples of things with poorly defined property rights.
Types of Externalities
Generally, externalities are categorized as either negative or positive.
1. Negative externality
A negative externality is a negative consequence of an economic activity experienced by an
unrelated third party. The majority of externalities are negative. Some negative
externalities, such as the different kinds of environmental pollution, are especially
harmful due to their significant adverse effects. Negative externalities are divided into
production and consumption externalities.
Examples
1. Air pollution
Air pollution may be caused by factories, which release harmful gases to the atmosphere.
Some of the gases include carbon monoxide and carbon dioxide. The destructive gases
cause damage to crops, buildings, and human health.
The high concentration of greenhouse gases in the atmosphere affects the global
climate and brings about extreme heat waves, rising sea levels, intense hurricanes, graded
air quality, and droughts. The release of toxic gases into the atmosphere adversely affects
vulnerable populations such as children, the elderly, and patients suffering from asthma
and heart diseases.
2. Water pollution

When industrial wastes are released into public waterways it pollutes and makes it
harmful to humans, animals, and the plants that depend on it. Factory wastes often
contain toxic chemicals that cause death to aquatic animals living in the water, and it
denies fishermen a source of income.
The contaminated water also affects plants that rely on clean water to survive. On the side
of humans, drinking water that is contaminated with industrial wastes poses a threat to
human life and can cause life-threatening diseases and even death.
 When there are negative externalities, the marginal social cost MSC is higher than the
marginal cost MC. The difference is the marginal external cost MEC. In the 1st pic a
profit-maximizing firm produces at q, where price is equal to MC. The efficient output is
q*, at which price equals MSC.In the 2nd pic the industry competitive output is q1, at the
intersection of industry supply MC1 and demand D. However the efficient output Q* is
lower, at the intersection of demand and marginal social cost MSC1.
Positive Externalities and Inefficiency

Externalities can also result in too little production, as the example of home repair and
landscaping shows. In the above fig, the horizontal axis measures the homeowner
investment.in repairs and landscaping. When there are positive externalities, marginal
social benefits MSB are higher than marginal benefits D. The difference is the marginal
external benefit MEB.A self-interested homeowner invests q1,in repairs, determined by
the intersection of the marginal benefit curve D and the marginal cost MC.The efficient
level of repair q* is higher and is given by the intersection of the marginal social benefit
and marginal cost curves.