What are externalities?

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 WHAT ARE EXTERNALITIES?

• Externalities refer to the unintended side effects or

consequences of an economic activity or transaction that
affect third parties who are not directly involved in that
activity or transaction.
• These effects can be either positive or negative and are
typically not reflected in the costs or benefits considered
by the individuals or entities involved in the activity.

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 Externalities

Externalities are spill-over effects from

production and/or consumption for which no
appropriate compensation is paid to one or
more third parties affected

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 Externalities

Externalities are spill-over effects from

production and/or consumption for which no
appropriate compensation is paid to one or
more third parties affected

Key Exam Point: Externalities lie outside the initial

market transaction and (without state intervention),
they are not reflected in the market price

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 WHY ARE EXTERNALITIES INEVITABLE?

• Inter-connectedness of Economic Agents: In a modern economy, individuals,

firms, and governments engage in a wide range of economic activities. These
interactions often have ripple effects that extend beyond the immediate parties
involved. For example, when a factory produces goods, it may emit pollutants into
the environment, affecting neighboring communities.
• Property Rights and Transaction Costs: Property rights are not always well-
defined, and transaction costs can be high, making it difficult to negotiate and
enforce agreements that internalize externalities.
• Public Goods: Public goods, such as clean air often cause positive externalities
because they benefit everyone, whether they contribute to their provision.
Individuals may underinvest in such goods, assuming others will bear the costs.

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 What are the main
types of externality to
know about, analyse
and evaluate?

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 WHAT ARE THE MAIN EXTERNALITIES?

• Negative externalities in production

• Negative externalities in consumption
• Positive externalities in production
• Positive externalities in consumption
• Mixed externalities

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 Negative Negative Positive Positive
Production Consumption Production Consumption
Externalities Externalities Externalities Externalities
Such as factory Such as household Such as Such as
pollution waste and noise reforestation vaccinations to
emissions or and air pollution projects and the protect public
waste from free-sharing of health during a
manufacturing academic pandemic
processes research

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 HOW DO EXTERNALITIES CAUSE MARKET FAILURE?

• Externalities can cause market failure because they disrupt the

efficient functioning of markets.
• Market failure occurs when the allocation of goods and services in a
free-market economy is not efficient or equitable - leading to
outcomes that are not in the best interest of society.
• This means that externalities lead to a net loss of social welfare
• Externalities can lead to market failures because the prices and
quantities determined by supply and demand in the market do not
account for these external costs or benefits.

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 What is the difference
between private cost
and external cost?

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 PRIVATE COST

Private costs are the internal costs

faced by the producer or consumer
directly involved in a transaction.
For example, the private cost of
owning and running a vehicle.
 PRIVATE COST EXTERNAL COST

Private costs are the internal costs External costs occur when the activity
faced by the producer or consumer of one agent has a negative effect on
directly involved in a transaction. the wellbeing of a third party. They
For example, the private cost of impose costs on other agents. This
owning and running a vehicle. causes social cost > private cost.
 What is the difference
between private
benefit and external
benefit?

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 PRIVATE BENEFIT

Private benefit is the benefit,

satisfaction or utility that an
individual agent such as a consumer
or a business derives from
producing or consuming something
 PRIVATE BENEFIT EXTERNAL BENEFIT

Private benefit is the benefit, Social benefits include private

satisfaction or utility that an benefits but also add in the external
individual agent such as a consumer benefits that might occur from
or a business derives from production and/or consumption
producing or consuming something
 Marginal Private Cost (MPC)

Marginal private cost is the internal cost

to a producer or consumer from
supplying or consuming one extra unit of
a good or service.

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 Marginal Private Benefit (MPB)

Marginal private benefit is the extra

benefit, satisfaction or utility gained by a
consumer or producer through
consuming or producing one extra unit of
a good or service.

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 How are private,
external and social
costs different?

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 PRIVATE, EXTERNAL AND SOCIAL COST

Marginal private cost Marginal external cost Marginal social cost

(MPC) (MEC) (MSC)

• The cost to a firm of • Cost to third parties • Total cost to society

producing / supplying (the wider society) arising from
an extra unit of from the production / producing /
output, or the costs consumption of an consuming an extra
to an individual of extra unit of output unit of output.
any economic • MSC = MPC + MEC
action/decision

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 Social Cost

Social cost = private cost + external cost

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 How is marginal social
cost expressed?

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 How is marginal social cost
expressed?
Marginal social cost =
marginal private cost +
marginal external cost

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 NET SOCIAL COST AND BENEFIT
A government is considering four investment projects. It has the resources to finance
and complete just one of these projects.
New city Airport
motorway New schools extension New hospitals

Private benefits 50 135 130 90

Private costs 120 80 100 65
Positive externalities 90 55 35 120

Negative externalities 60 20 60 45

Net private benefit -70 +55 +30 +25

Net social benefit -40 +90 +5 +100

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 PROPERTY RIGHTS AND EXTERNALITIES

• Property rights define and allocate ownership, control, and responsibilities

over resources and assets.
• When property rights are well-defined, it is easier to determine who should
bear the costs or enjoy the benefits of that activity.
• Well-defined property rights facilitate bargaining and negotiation between
parties involved in an economic activity
• Property rights can incentivize investment in technologies and practices that
mitigate negative externalities or create positive ones.
• Property rights can help prevent or mitigate the tragedy of the commons,
where shared resources are overused or depleted due to a lack of ownership.

EXTERNALITIES TUTOR2U.NET/ECONOMICS
 CATEGORISE

You have 60 seconds to categorise these eight items relating

to wind farms into one of four categories

Private Costs External Costs Private Benefits External Benefits

1) Less impact on personal 2) Lower taxpayer 3) Visual pollution for

health than fossil fuels subsidies required in LR some people

4) Fewer harmful gases 6) Cost of land +

5) Labour costs
emitted planning permission

7) Falling property prices 8) Employment created –

in area multiplier effects
 CATEGORISE
Private Costs External Costs Private Benefits External Benefits
6) Cost of land + 3) Visual pollution for 1) Less impact on personal 4) Fewer harmful gases
planning permission some people health than fossil fuels emitted

7) Falling property prices 8) Employment created –

5) Labour costs
in area multiplier effects

2) Lower taxpayer
subsidies required in LR

EXTERNALITIES TUTOR2U.NET/ECONOMICS