Subject: ECONOMICS

Class: M.A.
Semester: 4

Topic:
Externalities and Paraeto Optimality

Name of the Paper:

Pricing Theory and Social Welfare
Key words: Economies, Private marginal cost, Social marginal cost,
Private marginal benefit, Social marginal benefit

Dr. P N Maurya
Department of Economics
Faculty of Social Sciences
Mahatma Gandhi Kashi Vidyapith
Varanasi-02
E: mail: paraskvp@mgkvp.ac.in
EXTERNALITIES refer to the beneficial and detrimental effects of
any economic activity of an economic agent
( a firm ,a consumer, or an industry) on others.

The beneficial activities(externalities) by a consumer or a firm for

others are known as external economies.

The Detrimental or harmful activities (externalities) imposed on

others by an economic agent are known as external diseconomies.
EXTERNAL ECONOMIES AND DISECONOMIES IN PRODUCTION:

External economies occur, when the production of firm creates benefit,

part of which also goes to others. A firm may do it by two types –
By expanding its production, the firm may provide a direct service to
others when other firms have to pay no cost or nominal cost.
for example manpower training programme for laborers.
By expanding its production, a firm may make the supply of some
inputs cheaper for all the firms in industry.
For example pumping of water from mine or construction of bridge or
highways.
External diseconomies in production impose costs for other production
units without Reasonable and appropriate compensatory payments.
If the external economies exists the private marginal cost(PMC) of the
firm will be higher than the social marginal cost(SMC).
PMC > SMC
MARKET PRICE > SMC
Market price fixed on the basis of PMC will not reflect the SMC which
will be lower when external economies occur.

In the case of diseconomies price based on PMC will be lower than that
determined on the Basis of social cost.

PMC < SMC

MARKET PRICE < SMC
In absence of externalities (perfectly market condition or pareto
optimum)

All costs incurred and benefits received by producers and consumers

reflect in market prices.

No divergence between PMC and SMC as well as social marginal

benefit (SMB) and private marginal benefit (PMB).

PMC = SMC

PMB = SMB

In the presence of externalities:

PMC may greater or less than SMC and PMB also may be greater or
less than SMB.
 External economies and diseconomies in consumption

External economies in consumption: consumption of a person

creates beneficial effects on others.
For example: telephone , garden maintained by a person, etc.

External diseconomies in consumption: consumption of a person

creates unfavorable impact on other consumers.
For example: conspicuous consumption by a person causes a lot of
dissatisfaction to his friends and neighbourers.

The existence of external economies and diseconomies play a

significant role in determining the activities of production and
consumption in any economy.
Externalities can lead to the misallocation of resources.
they act as an obstacle to the attainment of pareto optimality
Or maximum social welfare governed by the invisible hand .

Existence of external economies result –

High private cost high market cost under production

Resulting as loss of social welfare (Pareto sub- optimum level).

Existence of external diseconomies result –

Low private cost low market price over production

Resulting as misallocation of resources and over production of socially

undesirable goods.
REFERENCE:

Ahuja, H L (2008):Advanced Economic Theory, S Chand and company ltd.new delhi