1.3.2: Externalities

• Negative production externality: Cost to a third party as a result of the production of a good
• Negative consumption externality: Cost to a third party as a result of the consumption of a good e.g passive smoking effect
• Private cost/benefit: Benefit or cost to an individual or a firm as a result of an economic transaction
• Social benefit: Private benefit + external benefit
• Social cost: Private cost + external cost
• Marginal private cost: Cost to the producer of producing one more unit of a good
• Marginal social cost: Cost to society of producing one more unit of a good
• Marginal private benefit: Benefit to the consumer of consuming one more unit of a good
• Marginal social benefit: Benefit to society of consuming one more unit of a good
• For a negative consumption externality, Marginal social benefit is less than Marginal private benefit.
• For a negative consumption externality, because MSB is less than MPB due to the negative externality, there will be overprovision of the good, as goods are produced at MPB = MSC rather than MSB = MSC

  
• For a negative production externality, MSC > MPC due to the externality, so the good will be overprovided
• Policy to address negative externalities: Restricting output of goods and services
• Policy to address negative externalities: Introduction of regulations in order to reduce pollution
• Policy to address negative externalities: Usage of indirect taxes in order to shift the MPC curve towards the MSC curve
• Positive consumption externality: Benefit to a third party as a result of the consumption of a good
• Positive production externality: Benefit to a third party as a result of the production of a good
• For a positive consumption externality, MSB > MPB. However as externalities are not taken into account, the market will underprovide goods, as they are produced at MPB = MSC rather than MSB = MSC
• The social optimum point is at MSC = MSB
• For a positive production externality, MSC < MPC, meaning goods will be underprovided by the free market
• Goods are produced at MPC or MPB as externalities are not taken into acount
• Policy to address positive externalities: Government provision of goods such as healthcare
• Policy to address positive externalities: Subsidies shift the MPC to the right
• Externalities are very difficult to measure