Externalities

• Externalities are spill-over or third-party effects resulting from the production or consumption of a good.
• When additional external benefits are present,

  MSB = MPB + MEB
• When additional external costs are present,

  MSC = MPC + MEC
• Third party refers to other people in society who are not directly involved in the market transaction.
• Positive externalities refer to the spill-over benefits enjoyed by a third party not involved in the production or consumption of a good.
• This is a positive externality graph.

  A) Benefit, Cost

  B) Quantity

  C) MSC = MPC

  D) MSB = MPB + MEB

  E) MPB

  F) Deadweight loss

  
• Rational and incentive-driven individuals will consume the private equilibrium output, Qp, where MPC = MPB.

  
• Due to the existence of MEB, the MSB is raised above the MPB. As a result, the socially optimum output, Qs, where MSB = MSC, is greater than Qp.

  
• Since Qs > Qp, and that individuals acting in pursuit of their self-interest would disregard the MEB to consume only up to Qp, there is the case of underconsumption, which in turn result in the loss of additional benefit to society, Qp Qs b c, and the avoidance of additional costs to society, Qp Qs b a.

  
• When there are positive externalities, the loss of additional benefits > the additional costs avoided, thus deadweight loss, a b c, is present.

  
• Negative externalities refer to the adverse effect experienced by a third party not involved in the production or consumption of a good.
• Rational and incentive-driven firms will produce the private equilibrium level output, Qp, where MPC = MPB.

  
• Due to the existence of MEC, the MSC is raised above the MPC. As a result, the socially optimum output, Qs, where MSB = MSC, is lesser than Qp.

  
• Since Qp > Qs, and that firms acting in pursuit of their self-interest would disregard the MEC and produce at Qp, there is a case of overproduction, which in turn result in a gain in additional benefit, Qs Qp a b, and a gain in additional cost, Qs Qp c a.

  
• When there are negative externalities, gain in additional benefits < gain in additional costs, thus deadweight loss, a b c, is present.