1.3.2: Externalities

• Private costs/benefits: Costs/benefits to the individual participating in the activity. The demand curve represents private benefits and supply curve represents private costs
• Social costs/benefits are the costs/benefits to society as a whole
• External costs/benefits are costs/benefits to a third party not involved in the activity. They are the difference between private costs/benefits and social costs/benefits
• Merit goods: Goods with external benefits, where benefit to society > benefit to individual. They are usually underprovided
• Demerit goods: Goods with external costs, where benefit to society < benefit to individuals. They are usually overprovided
• Marginal private benefit (MPB): Additional benefit that an individual receives from consuming an additional unit of a good/service
• Marginal social benefit (MSB): Extra gain to society from the consumption of one extra unit of a good
• Marginal private cost (MPC): The additional cost to the individual of producing one more unit of a good
• Marginal social cost (MSC): The additional cost to society of producing one more unit of a good
• Negative Externalities: Negative consequences to a third party resulting from the actions of a consumer or producer
• For negative externalities in production, Marginal social costs > Marginal private costs
• In a socially optimum market for production, MSC = MSB. As this is usually not the case, the gap between MSC and MPC is called the deadweight welfare loss
• For negative externalities in consumption, Marginal social benefit < Marginal private benefit
• In a socially optimum market for consumption, MSB = MPC. However as this is not usually the case the gap between MSB and MPB is the welfare gain
• Positive externalities: Benefits to third parties as a result of the actions of consumers or producers
• Government Policies used for negative externalities

  Indirect Taxes: Reduces quantity of demerit goods consumed

  Subsidies: Reduce costs of production and encourage consumption of demerit goods

  Regulation: To enforce less consumption of a good

  Provide the good directly

  Property rights: Encourage innovation as entrepreneurs can create new, protected ideas

  Personal carbon allowances: Tradeable permits allowing for the owner to pollute a certain amount