APPLICATIONS OF

ECONOMIC LAWS
(BASIC CONCEPTS)
Unit 4
EXTERNALITIES
Meaning
Externalities occur because economic agents have effects
on third parties that are not parts of market transactions.
Examples are: factories emitting smoke and did, jet plains
waking up people, or loudspeakers generating noise. These
activities are all having a direct effect on the well-being of
others that is outside direct market channels.

In these cases market prices (of soaps, air travel and

entertainment) may not accurately reflect social cost
because they take no account of the damage being done to
third parties. Information being conveyed by the prices is
fundamentally inaccurate, leading to a misallocation of
resources.
SOCIAL COST
 Social cost is the total cost to society. It
includes private costs plus any external
costs.
SOCIAL COST
 Costs of paying for petrol (personal cost)
 Costs of increased congestion (external cost)
 Pollution and worse air quality (external cost)
 The social cost includes all the above.
 Example of social cost – smoking

 If you smoke, the private cost is £6 for a packet of 20

cigarettes. But, there are also external costs to society
 Air pollution and risks of passive smoking
 Litter from discarded cigarette butts
 health costs
 The social costs of smoking include the total of all private
and external costs
SIGNIFICANCE
 Rational choice theory suggests individuals
will only consider their private costs.
 For example, if deciding how to travel, we
will consider the cost of petrol and time
taken to drive.
 However, we won’t take into consideration
the impact on the environment or congestion
levels for other members in society.
 Therefore, if social costs significantly vary
from private costs then we may get a socially
inefficient outcome in a free market.
 TYPES OF EXTERNALITIES
 Inter Firm (Production) Externalities

 Beneficial Externalities

 Externalities in Utility (Consumption Externalities)

 Public Goods Externalities

INTER FIRM EXTERNALITY
 Suppose there are two firms in the economy
 Firm I is producing X and firm II is producing Y.
 Each uses only single input, labour.
 The production of good Y is said to have an
external effect on the production of X if the
output of X depends not only on the amount of
labour chosen by firm I but also on the level at
which the production of Y is carried on.
 The Negative Externality is increase in output
of Y causes less of X to be produced.
BENEFICIARY/POSITIVE
EXTERNALITIES
 The activity of one firm may also have
beneficial effect on others.
 For example, if a power plant is set up near
a coal mine, hopefully, more coal can be
extracted due to an abundant supply of
power. 
UTILITY EXTERNALITIES
 Externalities also can occur if the activities
of an economic agent directly affect an
individual’s utility.
 Most obvious examples are environmental
externalities (such as noise from a loud radio
or smoking at public places ).
 Such externalities may some­times be
beneficial also. Like if somebody plays radio
on high volume, others can enjoy it also.
PUBLIC GOODS EXTERNALITIES

 Public goods or collective consumption goods

 Such as national defense, roads, bridges,
public parks, public school, hospitals, etc.
 Such goods create externality problems
because such goods can be allocated through
the market and those who enjoy such goods
do not pay prices directly.
PUBLIC GOODS CONTI…

 The cost of providing such goods is covered

through taxes. Once such goods are produced
(either by the government or by some private
agency) they provide benefits to all the
members of society. This is because such
goods are to be consumed jointly. It is not
possible to restrict these benefits to the
specific group of individuals who pay for
them.
TRANSACTION COST
 Transaction costs are costs incurred that
don’t accrue to any participant of the
transaction.
 It is a sunk cost resulting from economic
trade in a market. In economics, the theory
of transaction costs is based on the
assumption that people are influenced by
competitive self-interest.
TYPES OF TRANSACTION COSTS

1. Search and information costs

They are the costs associated with looking
for relevant information and meeting with
agents with whom the transaction will take
place. The stock exchange is one such
example, as they bring the buyers and
sellers of financial assets together. The
stock broker’s fee is a type of information
transaction cost as they provide relevant
information to mediate the market.
TYPES
2. Bargaining costs
They are the costs related to coming to an agreement that
is agreeable to the parties involved and drawing up the
contract. Bargaining costs can either be very cheap, such
as buying a newspaper, or can be very expensive, such as
trading a basketball player from one team to another.

3. Policing and enforcement costs

They are the costs associated with making sure that the
parties in the contract keep up their word and do not
default on the terms of the contract. In the real world,
people often deviate from the contract, and thus
enforcement costs are incurred while governing
contracts. Lawyer fees is an example of such a cost.
FACTORS AFFECTING/ELEMENTS
OF TC
Transaction cost economies consist of four elements:

 There is a lot of uncertainty and unpredictability in the world.

 With bargaining and asset specificity, organizations that enter
into transactions find it expensive to leave them.
 Individuals possess limited rationality, meaning they obtain and
process limited information, and hence, have fewer options to
choose from. Economic transactions are not based on pure
rationality but bounded rationality. Bounded rationality is a
form of rationality where a person’s decision-making and
rationality is limited by the amount of information available to
them and the finite amount of time that they need to decide.
 The inherent opportunistic behavior of individuals in an
economy makes it harder for contractual agreements to be
enforced after a long period of time.