EXTERNALITIES

1
EXTERNALITIES

• Externality a spillover effect associated with
  production or consumption that extends to a third
  party outside the market

2
External cost

• When production or consumption generates costs
  outside the market transaction
• Also referred to as negative externality

3
External benefits

• When production or consumption generates benefits
  outside the market transaction
• Also referred to as Positive externality

4
Environmental externalities

• Negative externalities exist when residuals cause
  damages, i.e. are pollutants
• Q. When does littering create external costs?
• A. Only when the litter harms someone else

5
Negative environmental externalities

• Sources of externalities from production
• Air pollution from a factory smokestack
• Water pollution from emissions into river
• Sources of externalities from consumption
• Household waste
• Noisy neighbors

6
Market failure when externalities exist

• Price does not reflect all the benefits or costs
  associated with production and consumption
• Market does not result in allocatively efficient
  quantity
• External costs ? overproduction
• External benefits ? underproduction

7
Modeling an external cost

• Terms
• Marginal private cost, MPC
• The costs borne by the producer for each
  additional unit
• Marginal external cost, MEC
• The costs of damages due to the production of
  each additional unit
• Marginal social cost, MSC
• MSC MPC MEC

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Benefit and cost functions
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Efficient allocation

• Net benefits would be maximized at the quantity
  where MB MSC
• Q 3000
• The market price at which consumers would buy
  this quantity is 40

10
Inefficiency of competitive equilibrium

• The equilibrium quantity in a competitive market
  which ignored external costs, Qp, would be found
  where MB MPC
• Qp 4000
• The equilibrium market price would be 20

11
Inefficiency of competitive equilibrium

• In general, in the presence of external costs, a
  market will
• Produce too much of the good that generates the
  negative externality
• Sell the product at a price that is too low

12
Inefficiency of competitive equilibrium

• Any correction of market failure that results in
  an efficient quantity of production
• Social gain equal to the reduction in external
  costs (area between MSC and MPC)
• Loss to producers of producers surplus from
  reduction in quantity
• Net social gain equal to the difference between
  social gain and lost profits

13
Net social gain from reducing production
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Net social gain from reducing production