1.3.2 Externalities

• Market Failure

  When competitive markets are not efficient for the whole economy usually because they do not benefit society as a whole
• Deadweight Loss


  The loss in producer and consumer surplus due to an inefficient level of production due to market or government failure
• External Costs

  Costs faced by a third party for which no appropriate compensation is forthcoming
• Marginal External Benefit


  Benefit to third parties from the consumption of extra units of output
• Marginal External Cost

  Cost to third parties from the production of an additional unit of output
• Marginal Private Cost


  Cost to a firm of producing an additional unit of output
• Marginal Social Benefit


  Total benefit to society from consuming an extra unit, MSB = MPB + MEB.
• Marginal Social Cost

  Total cost to society of producing an extra unit of output. MSC = MPC + MEC
• Negative Externalities


  When production and/or consumption impose external costs on third parties and no appropriate compensation is paid. This causes social costs to exceed private costs.
• Net Social Benefit

  A measurement of the net impact of an investment project by estimating the social costs and benefits. NSB helps a government decide which project(s) offers the best potential return for society.
• Positive Externalities


  When third parties benefit from the spill-over effects of production/consumption e.g. the social returns from investment in education & training
• Private/ Internal Benefit

  The rewards to individuals, firms or consumers from consuming or producing goods and services
• Private/ Internal Cost


  Costs of economic activity to individuals and firms
• Social Benefit

  The benefit of production or consumption of a product for society as a whole. Social benefit = private benefit + external benefit
• Social Efficiency

  The socially efficient output is where Social Marginal Cost (SMC) = Social Marginal Benefit (SMB)
• Spill-over Effects


  External effects of economic activity, which have a positive or negative impact on outsiders who are not producing or consuming a product
• Positive Externalities (Underconsumption of Merit Goods): At Q, merit goods are under-consumed then at Q* there is welfare gain due to positive third-party spill-over effects. At Q* the social optimum is achieved as social costs = social benefit

  
• Negative Externalities (Overproduction of Demerit Goods): Demerit goods yield social costs and are overproduced thus the MPC and MSC have a positive relationship as the quantity increases more demerit goods are consumed. From Q1 to Q there are negative third-party spill-over effects so there is a loss in welfare