WELLESLEY COLLEGE
DEPARTMENT OF ECONOMICS
JOHNSON
ECONOMICS 101
Review Notes on Externalities
Here, we briefly review the welfare analysis of externalities, with tables for each
of the cases. Note here that we've drawn cases for which the marginal externality benefit
or cost is not constant (thus the MSC or MSB curve is not drawn parallel to the S or D
curve), but the internalization policy will still be the same: tax markets with negative
externalities to reach Q efficient/optimal and subsidize markets with positive
externalities to reach Q efficient/optimal. Don't be too concerned with putting price lines
in for the consumer's and producer's prices in each case. Concentrate more on the idea
that I might consider reducing the SlJM of CS + PS + GR in exchange for either a
greatef increase in externality benefit or a greater reduction in externality cost. In both
cases, government action can increase TOTAL SS ( CS + PS + GR + Externality Effects)
by having the market participants take those external effects into account. Enjoy!
An externaHt)' is an effect on someone's well-being for which no compensation is provided in the
market. Pollution constitutes a negative (or detrimental) externality. Planting a beautiful garden
in onels front yard produces a positive (or beneficial) externality.
The marsinal social cost of producing a good consists of the cost to the producer ~ the cost of
any extemaHties that affect society.
Marginal private cost is shown by the supply curve. The marginal social cost curve is obtained by
taking the relevant supply curve and adding the marainal cost of the externality vertically at each
Qyantity. (Note that this marginal cost may be different at different quantities.)
The marsinal social benefit of consuming a good consists of the gain to the consumer JIli.nys the
cost ofany externalities that affect the rest of society.
Marginal private benefit is shown by the demand curve. The marginal social benefit curve is
obtained by taking the relevant demand curve and adding the marainal benefit of the externality
vertically at each Quantity.
Neiative production Externalitjes
As an example, consider The Daily Catch restaurant, which can prod~ce great calamari, but only
by causing the whole street to reek offish and garlic. This means that the marginal social cost
curve for calamari will be higher than the supply curve at all points, since the cost to the
restaurant ofproducing calamari does not take into account the effect of the bad smell on other
people. The difference may be greater for small amounts of calamari, since once the street reeks
adding a little more smell doesn't make things much worse.
MSC
P
S -MPC
MARGINAL COST OF
ETERNALITY AT 0'
0'
NEGATIVE PRODUCTION
EXTERNALITY
o
Social surplus is maximized at the quantity for which the marginal social benefit (MSB) from
consuming the good equals the marginal social cost (MSC) of producing it. If there are no
externalities, marginal social benefit equals the marginal private benefit, which is represented by
consumers' reservation prices and the demand curve. Further, marginal social cost equals the
marginal private cost, which is represented by the supply curve. Th~~, the social su.rpl~s
maximizing condition MSB = MSC becomes equiyalent to the condition D = S, which
automaticalJy satisfied by a competitive market equilibrium.
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If there are externalities, however, the competitive market equilibrium level of output is nQ1 the
social surplus maximizing level of output. Thus the competitive market equilibrium represents a
deadweight loss. Here is the situation in our calamari example:
P
D -MPB-MSB
"------'-_......:..._---~Q
QEFF
Q HKT .
NEGATIVE PRODUCTION
EXTERNALITY
With a negative externality the market produces more calamari than the social surplus maximizing
amount. Why?
When the last units ofQ were produced, the market thought that their benefits (what people were
willing to pay, the demand curve) slightly outweighed the costs of production (the supply curve),
so the market said "go ahead and produce." In fact the costs to society (the cost of production
plus the externality) were greater than the benefits,so w~ want the markc;t to say "don't produce
anymore."
We can use the above diagram to find the total additional cost associated with the externality at
QMKT and QEFF. The additional cost is the difference between the MSC curve and the supply
curve for all units produced. Thus, at QMKT the cost of the externality is B + C + D; at QEFF the
cost ofihe externality is B. Notice that the cost of the externality does not go away at the
efficient quantity, but it is lessened.
Now that we can find the cost of the externality, we can use a welfare table to find the deadweight
loss that occurs when Qt.~T is produced. The welfare table for externalities is different from the
previous welfare tables you have used in two ways:
+Go,/-t.
1.
~~.
Instead offinding consumer surplus and producer surplus~eparately, we will lump them
together. This means that we will not have to worry about what the price is at the market
quantity and the efficient quantity; we can simply look for the area between the demand
curve and the supply curve. When the demand curve is above the Aupply curve (the usual
case), this area represents positive consumer and producer surplu\f\lWhen the supply
curve is above the demand curve (we will see this when we do positive externalities), this
area represents neBative consumer and producer surplus.+ 6~
2.
The cost of the externalities is included in social surplus. The basic formula we will use is
+
(consumer surplus + producer surplus)
q~
- additional costs of negative externalities
+ additional benefits of positive externalities.
social surplus =
To find the deadweight loss associated with an externality, we calculate total social surplus at the
efficient level of output, then calculate total social surplus at market level of output, and then use
these quantities to find the chanBe in total social surplus that occurs when the market level ~i
output is produced instead ofthe efficient level of output.
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6~ ~ ~
ett
k~~ ([ ~~1 b1~ +G\~ ~ S~~.:::J 'S ~Ql lA.~
At
Consumer Surplus +
Producer Surplus + ~ft
-
Total Cost of
Negative Externality
Social Surplus
QEFF
At
t1
•
Difference
QMKT
A+B
A+B+C
C
B
B+C+D
C+D
A
A-D
-D
As the table shows, the deadweight loss that occurs when
QMKT
is produced is D.
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Suppose that in our calamari example people ~ the smell of garlic and fish. Then the Daily
Catch would be generating a positive externality and the marginal social cost of producing
calamari would be ~ than the marginal private cost. In other words, the social cost equals the
private cost of production m.imI.s the benefits to people walking down the street. In this case the
market will produce less calamari than the amount which would maximize social surplus.
p
-
QMKT
POSITIVE PRODUCTION EXTERNALITY
MSB
We can find the area that represents the total additional benefit associated with the positive
production externality. The total additional benefit is the area between the supply curve and the
MSC curve for all units produced. At QEFF the additional social benefit associated with the
externality is B + C + D; at Q~{},.'T the additional social benefit is B.
Once again we can use a welfare table to find the deadweight loss that occurs when
produced.
At
At
QEFF
QMKT
QMKT
Difference
Consumer Surplus +
Producer Surplus +6«
A-D
A
D
+ Total Benefit of
Positive Externality
B+C+D
B
-C-D
Social Surplus
A+B+C
A+B
-C
The deadweight ]oss associated with
Qfo.fKT
is
is C.
J;xternaUtjes of Consumpti on
So far we have discussed positive and negative externalities generated by the production of
goods. There are also externalities generated by the consumption of goods. Alcohol and garlic
bread have negative externalities associated with their consumption, while education and soap
have positive externaliti"es associated with their consumption.
For ne~atiye consumption externalities, we have the following situation:
p
MARGINAL
COST OF
EXTE~ITY
S =MPC=MSC
w:::;..
....:-_-....:.
OE:ff
~~o
OMK!
NEGATIVE CONSUMPTION EXTERNALITY
For negative consumption externalities, the additional cost associated with the externality is the
area between the demand curve and the MSB curve for all units produced.
A+B
A+B+C
C
1~J
A
A+C+D
C+D
-to
B
B-D
-D
At
At QEfF
~onsumer Surplus
+
Q~{KT
Difference
Producer Surplus
Total Cost of
Negative Externality
Social Surplus
Kef\~
Qeff
The deadweight loss that occurs when Q~{KT is produced is area D.
For positive consumption externalities, we have the following situation:
Q
MKT
EFF
Q
Q
POSITIVE CONSUMPTION
EXTERNALITY
For positive consumption externalities, the additional benefit associated with the externality is the
area between the MSB curve and the demand curve for all units produced.
At QEFF
Consumer Surplus +
Producer Surplus
At
Q~{KT
Difference
B-D
B
D
+ Total Benefit of
Positive Externality
A+C+D
A
-C-D
Social Surplus
A+B+C
A+B
-C
In this case of a positive consumption externality, the deadweight loss associated with producing
QMKT is equal to C.
Some final thoughts:
*In cases of negative externalities, the government has a positive economic role to tax to
reduce the quantity transacted. As we saw in lecture, they may either tax the good
(electricity or gasoline) or they may use a Pigovian tax or permit scheme to tax the
negative externality itself (pollution).
*In cases of positive externalities, the government has a positive economic role to
subsidize to increase the quantity transacted.
*Try to convince yourselves that total social surplus is the area bounded by MSB and
MSC up to Q efficient/optimal.
*Even with negative externalities, some non-zero production and consumption of the
good is generally optimal. After all, not many would argue that the negative pollution
externality is so very large that setting gasoline quantities to ZERO would be socially
optimal. The idea is to make sure that the quantity takes all parties into account - the
gasoline makers, the gasoline users, and the cyclists who like to breathe and ride at the
same time!