1.3.2 Externalities

• Private costs:


  Cost paid by a firm to produce a good or service (e.g. wages, raw materials).
• External costs (AKA negative externality):


  Cost of producing a good to third parties.
• Social costs:


  Private costs + external costs
• Negative externality


  When the production of a good leads to external costs for third parties

  E.g. a factory emitting harmful gases.
• How do negative externalities of production cause market failure?

  Equilibrium quantity is where D(MPB) = S(MPC).

  Because of external costs MSC>MPB. If there are no external benefits, then MPB=MSB.

  The efficient or socially optimum Q is where MSB=MSC. This Q is below the equilibrium Q, so the good is overproduced.

  Therefore, too many scarce resources are allocated to the production of this good. This is inefficient and results in market failure and welfare loss.

  
• Private benefits:


  Benefit to a consumer of consuming a good.
• External benefits:


  Benefits to third parties of a good being consumed.
• Social benefits:


  Private benefits + external benefits
• Positive externality of consumption


  When the consumption of a good leads to external benefits to third parties.

  E.g. education and vaccines.
• How do positive externalities cause market failure?

  Equilibrium quantity is where D(MPB) = S(MPC).

  Because of external benefits MSB>MPB. If there are no external benefits, then MPC=MSC.

  The efficient or socially optimum Q is where MSB=MSC. This Q is above the equilibrium Q, so the good is underproduced.

  Therefore, too few scarce resources are allocated to the production of this good. This is inefficient and results in market failure and welfare loss.