Externalities

Learning Objectives

By the end of this section, you will be able to:

 Explain and give examples of positive and negative externalities.

Our assumption throughout this analysis, however, was that there was no third party impacted
by the interaction of producers and consumers. We can now add the concept
of Externalities to our supply and demand model to account for the impact of market
interactions on external agents. We will find that the equilibrium that is optimal
for consumers and producers of the good may be sub-optimal for society. We will learn that
the all-regulation-is-bad-regulation conclusion from earlier is not always the case – in many
situations, we can improve societal outcomes with policy. Before we get to this conclusion,
let’s first unpack this concept of externalities.

Externalities

To this point, we have modelled private markets. Private markets only consider consumers,
producers and the government – the impacts on external parties is irrelevant. The perfectly
competitive market we modelled offered an efficient way to put buyers and sellers together
and determine what goods are produced, how they are produced, and who gets them. The
principle that voluntary exchange benefits both buyers and sellers is a fundamental building
block of the economic way of thinking. But what happens when a voluntary exchange affects
a third party who is neither the buyer nor the seller?As an example, consider a club
promoter who wants to build a night club right next to your apartment building. You and your
neighbours will be able to hear the music in your apartments late into the night. In this case,
the club’s owners and attendees may both be quite satisfied with their voluntary exchange,
but you have no voice in their market transaction. The effect of a market exchange on a third
party who is outside or “external” to the exchange is called an externality. Because
externalities that occur in market transactions affect other parties beyond those involved, they
are sometimes called spillovers. Externalities can be negative or positive. The club example
from above is that of a negative externality. The club imposed a cost on you, an external
agent to the market interaction. A positive externality occurs when the market interaction of
others presents a benefit to non-market participants.

Enriching Our Model

As discussed earlier, we have previously modelled private markets. Thus, the terminology we
used in that analysis applies to private markets. The terms consumer surplus, producer
surplus, market surplus, and the market equilibrium (note that this will be referred to
interchangeably in this chapter as the unregulated market equilibrium) derive their meaning
from an analysis of private markets and need to be adapted in a discussion where external
costs or external benefits are present.
 For the purpose of this analysis, the following terminology will be used:

 Our topic three demand curve is equivalent to the marginal private benefit curve.
 Our topic three supply curve is equivalent to the marginal private cost curve.

We now want to develop a model that accounts for positive and negative externalities. To do
so, we must consider the external costs and benefits. External costs and benefits occur when
producing or consuming a good or service imposes a cost/benefit upon a third party. When
we account for external costs and benefits, the following definitions apply:

 When we add external benefits to private benefits, we create a marginal social benefit
curve. In the presence of a positive externality (with a constant marginal external benefit),
this curve lies above the demand curve at all quantities.
 When we add external costs to private costs, we create a marginal social cost curve. In the
presence of a negative externality (with a constant marginal external cost), this curve lies
above the supply curve at all quantities.

When we were considering private markets, our objective was to maximize market surplus or
total private benefits minus total private costs. Our new objective considering all impacted
agents in society is to maximize social surplus or total social benefits minus total social costs.
Recall that in this course, our diagrams reflect “marginal” quantities. Notice that some of the
definitions require you to use “total” quantities. Remember that to derive a “total” from a “marginal,”
take the area underneath the marginal up to a quantity of interest. This quantity is often the
equilibrium.

A Negative Externality

Much of the work we will do is with negative externalities. As we will see in the next section,
pollution is modelled as a negative externality. Economists illustrate the social costs of
production with a demand and supply diagram. For example, consider Figure 5.1a, which
shows a negative externality. Notice that there are external costs but no external benefits.
Graphically, this means that the marginal social cost (MSC) curve lies above the marginal
private cost (MPC) curve by an amount equal to the marginal external cost (MEC) and the
marginal private benefit (MPB) and marginal social benefit (MSB) are equivalent.

Let’s undergo an analysis of this diagram to understand how we need to shift our thinking
from Topic 3 and 4 to Topic 5.
 Figure 5.1a

Let’s first pretend we know nothing about externalities and ignore MSC. Market equilibrium
in this diagram occurs at the intersection of supply and demand, or the intersection of MPC
and MSB (which is equivalent to MPB). This occurs at Q 1. Now we know that total private
benefits at the market equilibrium are equal to a+b+c+e+f and we know that total private cost
at the market equilibrium equals c+f.

The market surplus at Q1 is equal to (total private benefits – total private costs), in this
case, a+b+e. [(a+b+c+e+f) – (c+f)].

Now, let’s introduce some of the concepts we’ve learned in this section to our analysis. To
get a true picture of surplus, we need to account for the external cost of production. Recall
that social surplus is the difference between total social benefits and total social cost. Social
surplus is sometimes referred to as aggregate net benefits. Since there is no positive
externality, social benefit and private benefit are equal. Thus, as before, it is equal to
a+b+c+e+f.

Total social cost at the market equilibrium is equal to b+c+d+e+f, and includes all the areas
under our MSC curve up to our quantity. Notice that this is larger than total private cost by
b+e+d. This should make sense as we are analyzing a negative externality where, by
definition, the private cost to producers is smaller than the social cost of their actions. The
difference is these two values is equal to the external costs.

The social surplus at Q1 is equal to total social benefits – total social costs. In this case, a-
d. [(a+b+c+e+f) – (b+c+d+e+f)].

In Topic 3 and 4, we saw that the market equilibrium quantity maximized market surplus and
that any move away from this quantity caused a deadweight loss. Let’s see if this conclusion
holds when we introduce externalities.
Recall that deadweight loss (DWL) is defined at maximized surplus – actual surplus. In Layman’s
terms, it is where we want to be in a perfect world minus where we are now. In some sense, it is a
quantification of inefficiency.

Consider our diagram of a negative externality again. Let’s pick an arbitrary value that is less
than Q1 (our optimal market equilibrium). Consider Q2.
 Figure 5.1b

If we were to calculate market surplus, we would find that market surplus is lower at Q2 than
at Q1 by triangle e.

The market surplus at Q2 is equal to area a+b. [(a+b+c) – (c)].

What about social surplus? Total social benefit at Q2 is equal to a+b+c. Total social cost at
Q2 is equal to b+c.

The social surplus at Q2 is equal to area a [(a+b+c) – (b+c)].

This result is interesting. By moving to a quantity lower than our optimal market equilibrium,
we raised social surplus. Compared to Q1 we have increased our social surplus by area d. This
means that d was a deadweight loss from being at the optimal market level of production.
That is to say, the optimal market level of production was inefficient for society. By leaving
the market unregulated and letting the interaction of producers and consumers set quantity
and price, society as a whole is worse off than if quantity had been restricted by policy for
example. This means that there is an opportunity for government intervention to make society
better off.

Why is this the case? Well, at Q1, we see that our MSC is greater than our MSB. Using
marginal analysis, we know that when MC > MB, we need to reduce our quantity to
maximize surplus.

Positive Externalities

As we mentioned previously, a positive externality occurs when the market interaction of

Notice first that MPC curve is the same as MSC curve because there are no external costs.
Second, the MSB curve lies above the MPB curve at all quantities because each unit of
private consumption generates a spill-over benefit to non-market participants. The area in
between MSB and MPB is the external benefit. Remember that MPB + MEB = MSB.

Let’s briefly explore this diagram as we did for negative externalities. The market
equilibrium occurs where MPB = MPC. That occurs at Q1.

The market surplus at Q1 is equal to total private benefits – total private costs, in this
case b. [(b+c) – (c)].

The social surplus at Q1 is equal to total social benefits – total social costs, in this
case a+b. [(a+b+c) – (c)].

As before, suppose we increased the quantity in this market to Q2.

The market surplus at Q2 is equal to b-f. [(b+c+g) – (c+f+g)].

The social surplus at Q2 is equal to a+b+d. [(a+b+c+d+f+g) – (c+f+g)].

Note that social surplus has increased despite the fact that market participants are worse off.
Thus, a Potential Pareto Improvement must have occurred. We can see this is the case by
noticing that d+f is the amount that non-market participants gained by the increase in
production and that f is the loss to market participants from excess production. In theory, we
could take f from the external agents and give it to the market participants so they would be
indifferent to the situation before and after the change. Thus, we know that d is the
deadweight loss in the presence of a positive externality, due to under production.

Glossary

External Benefits
additional benefits reaped by third parties outside the production process when a
unit of output is produced
External Cost
additional costs incurred by third parties outside the production process when a
unit of output is produced
Externality
a market exchange that affects a third party who is outside or “external” to the
exchange; sometimes called a “spillover”
Market Failure
When the market on its own does not allocate resources efficiently in a way that
balances social costs and benefits; externalities are one example of a market
failure
Negative Externality
a situation where a third party, outside the transaction, suffers from a market
transaction by others
Positive Externality
a situation where a third party, outside the transaction, benefits from a market
transaction by others
Private Market
a market that only considers consumers, producers and the government, doesn’t
include external agents
Social Costs
costs that include both the private costs incurred by firms and also additional costs
incurred by third parties outside the production process, like costs of pollution
Spillover
see externality