Chapter 10 – Externalities
Externality: the uncompensated impact of one’s actions on the well-being of a bystander.
Internalizing externality: altering incentives so people take account of external effects of actions
It is difficult to be efficient if there are a lot of interested parties transaction costs = difficult
Optimal value = social value not always equilibrium
When a market is in equilibrium, with no external influences/effects, it’s in a state of Pareto
optimality: it’s impossible to make someone better off without making someone worse off. This
does not mean everyone is equal. The market is socially efficient: community surplus is maximised.
At any lower Q, social value > costs, and any higher Q,
the cost of the last unit > social value.
S is private cost, and D is private value
Supply = marginal social cost (MSC) marginal cost to
whole community (including externalities)
Demand = marginal social benefit (MSB) marginal
benefit to whole community (including externalities)
Existence of externalities
Externality occurs when the production/consumption of a good/service affects a third party
MPC (marginal private cost): private supply curve that is based on the firm’s costs of production.
MSC = MPC +/- any external cost/benefit of production.
MPB (marginal private benefit): private demand curve that is based on the utility/benefits to
consumers. MSB = MPB +/- any external cost/benefit of consumption.
Thus, if no externalities exist in a market, MSC = MSB and there’s social efficiency and maximum
community surplus. If externalities exist, MSC does not equal MSB, so there is market failure.
1) Negative externalities of production: when the production of a
good/service creates external costs. MSC > MPC. The firm is only
concerned with its private costs, and will produce at market equilibrium,
not optimal (where MSC = MSB), so there is market failure. Too much is
produced for too low a price. There is a welfare loss = yellow triangle.
Total cost to society is between MSC and Qmkt, so F + G + B + C + H.
Q mkt Qopt Change
Consumer surplus F + G + B + C + H D - (A + B + C)
Producer surplus E – (B + C + H) A + E A + B + C + H
= (E + F + G) – TC
Total surplus D + A + E – H D + A + E H
2) Positive externalities of production: production creates external
benefits. The firm produces below socially efficient level. There is a
potential welfare gain shown by the triangle, where MSB > MSC.
A. Subsidize the cost. MPC shifts right by subsidy, to MSC
3) Negative externalities of consumption: when products are
consumed, they negatively affect third parties. Hence, MSB < MPB. But
consumers consume at Q1 (MSC = MPB), ignoring negative externality
(triangle). Hence, they over-con