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Externalities
Externality exists when the actions or decisions
of one person or group impose a cost or bestow
a benefit on second or third parties.
Externalities are sometimes called spillovers
effects or neighborhood effects. Inefficient
decisions result when decision makers fail to
consider social costs and benefits.
DEFINITION
externality A cost imposed or benefit bestowed on
an individual or a group that is outside, or external
to, the transaction.
Examples : Air, water, land, sight, and sound
pollution; traffic congestion; automobile accidents;
abandoned housing; nuclear accidents; and
secondhand cigarette smoke.
Characteristics of Externalities
1 Externalities can be produced by consumers as well
as by companies.
2 Externalities are reciprocal in nature.
3 Externalities can be positive or negative.
4 Public goods can be viewed as a special kind of
externality.
5 True externalities are not reflected in market prices.
Why does externalities pose problems for
resource allocation in a market system?
The conditions for Pareto optimal allocation of
resources are different in the presence of
externalities and public goods than when the
competitive market assumptions are satisfied.
This means that competitive markets do not
allocate true externalities and public goods
effectively.
In general, too little of public goods will be
supplied by the private market and too many
negative externalities will be produced by the
private market.
NEGATIVE EXTERNALITY
When a negative externality exist , the price of a good or
service does not reflect the full marginal social costs
(MSC) of resources allocated to its production.
There is an extra cost to third parties referred to as the
marginal external cost (MEC). This is the extra cost to
third parties of the production of another unit of the
good producing the negative externality.
MEC is a true incremental cost that is not included in
the price.
External Cost or negative externality
S = MPC
$100
D = MSB
5
External Cost or negative externality
S = MPC
$100
10
MEC
5
D = MSB
MSC = MPC + MEC
10
S = MPC
$ 110
$ 105
$100
D = MSB
4.5
5
MSC = MPC + MEC
10
$ 110
S = MPC
C
B
$ 105
$100
A
Social Gain from reducing
production
D = MSB
4.5
5
Class Exercise
The manufacturer of trucks produce pollution
of various kinds. Producing a truck creates one
unit of pollution and a unit of pollution has
a cost of $3,000. Imagine that the supply of
trucks is competitive. The market supply and
demand for trucks is shown in the Table.
P
19
20
21
22
23
24
25
Qs
480
540
600
660
720
780
840
Qd SMC
660
630
600
570
540
510
480
Plot the supply and demand curve for the truck market and find the private
market equilibrium price and quantity.
The equilibrium price and quantity
Price
($000)
19
20
21
22
23
24
25
Quantity
Supplied
480
540
600
660
720
780
840
Quantity
Social Marginal
Demanded
Costs
660
630
600
570
540
510
480
21
S = MPC
D
600
Class Exercise
Since Producing a truck creates one unit of pollution
and a unit of pollution has a cost of $3,000. And If the
social costs of pollution are taken into account, then the
equilibrium price and quantity became as follow:
Price
($000)
19
20
21
22
23
24
25
Quantity
Supplied
480
540
600
660
720
780
840
Quantity
Social Marginal
Demanded
Costs
660
19+3=22
630
20+3=23
600
21+3=24
570
22+3=25
540
23+3=26
510
24+3=27
480
25+3=28
The New Equilibrium Price and Quantity
MSC
S = MPC
23
21
D
540 600
external benefit or positive externality
For a positive externality,
prices do not fully reflect the
marginal social benefits of a
good or service.
The marginal external
benefit (MEB) is the
additional benefit to a third
party of an additional unit of
output being produced.
Gain from
increasing
output S
Z
45
30
25
10
V
U
H
D = MPB
10 12
MPB +
MEB =
MSB
Internalization of Externalities
Internalization of an externality occurs when the marginal
private benefits or costs of goods and services are adjusted so
that the users consider the actual marginal social benefit or
cost of their decisions.
In the case of a negative externality, the MEC is added to MPC
for internalization.
For a positive externality, the MEB is added to MPB to
internalize the externality.
Internalizing the externality results in changes in prices to
reflect full MSC or benefit of a good.
Basic Issue
When there are public consequences of private
decisions, the usual competitive market process has no
mechanism for incorporating the cost or benefits of
those public consequences.
The producer of a negative externality is imposing
external costs on others, while the producer of a
positive externality is producing external benefits (
e.g., a public good ).
Pigouvian Tax
Pigouvian Tax is a Method of Internalizing Negative
Externalities
This tax is designed to adjust the MPC of a good to internalize
the externality.
The tax must equal the MEC per unit of output to achieve this
objective.
The tax is designed to internalize a negative externality by
making sellers of the product pay a fee equal to the MEC per
unit of output sold.
MSC = MPC + MEC
10
$ 110
F
G
B
$ 105
A
$100
$95
S = MPC
H
J
D = MSB
4.5
5
MSC = MPC + MEC
S = MPC
$ 110
F
B
$ 105
$95
A
Tax Revenue =
Total External Costs
$100
10
G
H
Gain in Well-Being
J
D = MSB
4.5
5
Internalizing Negative Externality Associated
With Goods Sold in Monopolistic Markets
Suppose that a negative externality is associated with
output sold by a monopoly.
In a monopoly case two distortions exist. One do to
monopoly power and another do to the existence of
the negative externality.
In the case of monopoly power, to little output is
produced in the context of economic efficiency.
For the negative externality too much output is being
produced.
This situation creates a policy dilemma.
Short of breaking up the monopoly and then taxing
the competitive company, another solution exists.
The monopoly initially is producing an annual output
level ( Qmonompoly ) lower than the Efficient quantity ( Q * ).
This is Equivalent to saying that it is behaving as a
perfectly competitive industry for which marginal cost
has been increased two account for the negative
externality.
In fact, the monopolistic distortion can offset part or all of
the distortion resulting from the negative externality.
MPC + MEC = MSC
MPC
F
Pm
A
+ externality gains
B
monopolistic losses
C
MR
Qm
Q*
D = MSB
Summary
A negative externality (also called "external cost" or
"external diseconomy") is an economic activity that imposes
a negative effect on an unrelated third party. It can arise
either during the production or the consumption of a good
or service
Many negative externalities are related to the environmental
consequences of production and use.
Summary
Examples for negative production externalities include:
Air pollution from burning fossil fuels. This activity causes damages
to crops, (historic) buildings and public health.
Anthropogenic climate change as a consequence of greenhouse
gas emissions from burning oil, gas, and coal.
Water pollution by industries that adds effluent, which harms plants,
animals, and humans.
Noise pollution during the production process, which may be
mentally and psychologically disruptive.
Negative effects of Industrial farm animal production.
The depletion of the stock of fish in the ocean due to overfishing.
Summary
Examples for negative consumption externalities include:
Sleep deprivation due to a neighbor listening to loud music late at
night.
Antibiotic resistance, caused by increased usage of antibiotics.
Shared costs of declining health and vitality caused by smoking
and/or alcohol abuse.
Higher congestion costs and increased accident risks when people
use public roads.
Consumption by one consumer causes prices to rise and therefore
makes other consumers worse off, perhaps by reducing their
consumption.
General Theory of Second Best
Positive Externality
Examples of positive production externalities include:
• A beekeeper who keeps the bees for their honey. A side effect or
externality associated with such activity is the pollination of
surrounding crops by the bees. The value generated by the pollination
may be more important than the value of the harvested honey.
• The construction and operation of an airport. This will benefit local
businesses, because of the increased accessibility.
• An industrial company providing first aid classes for employees to
increase on the job safety. This may also save lives outside the factory.
• A foreign firm that demonstrates up-to-date technologies to local firms
and improves their productivity.
General Theory of Second Best
Positive Externality
Examples of positive consumption externalities include:
• An individual who maintains an attractive house may confer
benefits to neighbors in the form of increased market valuesfor their
properties.
• An individual receiving a vaccination for a communicable
disease not only decreases the likelihood of the individual's own
infection, but also decreases the likelihood of others becoming
infected through contact with the individual.
• Driving an electric vehicle charged by electricity from a renewable
source, reducing greenhouse gas emissions and improving local air
quality and public health.
Positive Externality
Examples of positive consumption externalities include:
• Increased education of individuals, as this can lead to broader society
benefits in the form of greater economic productivity, a
lower unemployment rate, greater household mobility and higher rates
of political participation.
• An individual buying a product that is interconnected in a network (e.g.,
a smartphone). This will increase the usefulness of such phones to other
people who have a video cellphone.
• In an area that does not have a public fire department, homeowners who
purchase private fire protection services provide a positive externality to
neighboring properties, which are less at risk of the protected neighbor's
fire spreading to their (unprotected) house.
General Theory of Second Best
Pigouvian Subsidy or positive externality
Pigouvian Subsidy is a means of internalizing positive
externality
This subsidy is considered a payment made by
government to either the buyers or sellers of a good.
so that the price paid by consumers is reduced.
This payment must equal the MEB of the good.
S = MSC
Z
45
30 R
25
V
Subsidy Payment
‫فيديو‬
U
D’ = MPBi + $20 = MSB
X
10 Y
D = MPB
10
12
Welfare analysis
With and without externalities: we can use a form of economic
theory called welfare analysis to show why it is socially
preferable to internalize externalities.
The main idea is that the area on a supply and demand curve
can be used to measures total benefits and costs. The area
under the demand curve shows total benefits; the area under the
supply curve shows total costs.
Welfare analysis of the automobile market
without externalities
P
S
A
Consumer
surplus
P0
Producer
surplus
B
C
Total cost
Qs,d
Q0
D
The total value of (Q0) unites
purchased is shown by areas
(A+B+C). The total cost of purchasing
these unites is area (c). Then the net
social benefit from the production
and consumption of (Q0) unites is
(A+B).
Welfare analysis of the automobile market
without externalities
P
Consumer
surplus
S
A
P0
Producer
surplus
B
D
C
Total cost
Q1
Q0
Qs,d
Economists call market
equilibrium efficient because it
maximizes net social benefit.
If we were to produce less than
(Q0) units, or more, net benefit
would be less than at (Q0). At
(Q1) the net benefit is only part of
the area (A+B).
Welfare analysis of the automobile market
without externalities
P
S
Consumer
surplus
A
D
P0
Producer
surplus
Net
losses
B
D
C
Total cost
Q0
Q2
Qs,d
At (Q2) we realize the full net
benefit (A+B) but we also
experience some net social loss,
shown here by area (D).The
overall social benefit, then is
(A+B-D), a lower amount than at
(Q0).
Welfare analysis with externalities
P
S + Externality
consumer
surplus with
External
Cost
Producer P0
surplus with
External
Cost
A
S
Net
Social
losses
D
C
B
D
C
Total private cost
Q1
Q0
Qs,d
The combination of private
and external costs gives a
social cost curve (S ), which
lies above the ordinary
supply curve. The market
private equilibrium ( Q0) no
longer maximizes net social
benefits.
Welfare analysis with externalities
P
With the new higher total
social cost curve, social
benefit is only A B
S + Externality
consumer
surplus with
External
Cost
Producer P0
surplus with
External
Cost
A
S
Net
Social
losses
D
C
B
D
C
Total private cost
Q1
Q0
Qs,d
The area ( D ) is social loss, so
that the overall net social benefit
is A B D
Welfare analysis with externalities
P
S + Externality
consumer
surplus with
External
Cost
Producer P0
surplus with
External
Cost
A
S
Net
Social
losses
D
Notes that, the area indicates the
total cost of pollution at point Q0 is
C
B
D
C
Total private cost
Q1
Q0
We would do better to lower
equilibrium to (Q1 ), avoiding the net
social loss (D ), and of course this is
exactly what we seek to accomplish
with a pollution tax.
Qs,d
C
D
But of this total cost, only (D ) is
considered net social loss.