Positive and Negative Externalities in Consumption and Production

Positive and Negative Externalities in Consumption and Production

1. EXTERNALITIES= costs or benefits that spill over to third parties external to a market transaction

   • Occur outside of the market, affecting individuals not directly involved in the production and/or consumption of a particular good or service

2. MARGINAL PRIVATE COST= the cost to an individual or firm of an economic transaction

3. MARGINAL EXTERNAL COST= the spillover cost to third parties of an economic transaction

4. MARGINAL SOCIAL COST= the full cost to society of an economic transaction, including private and external costs

5. MARGINAL PRIVATE BENEFIT= the benefit to an individual or firm of an economic transaction

6. MARGINAL EXTERNAL BENEFIT= the spillover benefit to third parties of an economic transaction

7. MARGINAL SOCIAL BENEFIT= the full benefit to society of an economic transaction, including private and external benefits

8. NEGATIVE EXTERNALITIES= costs imposed on a third party not involved with the consumption or production of the good

9. POSITIVE EXTERNALITY= a positive spillover effect to third parties of a market transaction

10. Negative externalities

    • social costs > private costs
    • the individual consumer does not take into account the effect of externalities in their calculations
    • e.g. if you make a car journey you only consider the things affecting you like petrol cost and congestion charges or tolls you must pay, you would not seriously consider additional costs you may be imposing on others like congestion, pollution or other environmental damage
    • marginal social cost= marginal private cost + marginal external cost

11. Positive externalities

    • social benefits > private benefits
    • e.g. if you go to the doctors and are inoculatd against a disease then you benefit from not catching the disease, but others who come into contact with you also benefit as they are less likely to get that disease
    • marginal social benefit= marginal private benefit + marginal external benefit

12. Externalities as market failure

    • Externalities will lead to the wrong amount of the product being produced; goods with negative externalities will be over-produced and goods with positive externalities will be under-produced
    • e.g. a firm running a coal-fired power station will not consider atmospheric pollution when calculating prices for their electricity, the cost will be lower than if the full social cost (private costs + external costs) were to be considered
      • This is OVER-PRODUCTION LEADING TO A NEGATIVE EXTERNALITY
        • shifts supply
    • e.g. education may be available but it will be under-consumed in a free market as people do not consider the full social benefits (private benefits + external benefits) when consumed
      • This is UNDER-PRODUCTION LEADING TO A POSITIVE EXTERNALITY
        • shifts demand

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