MODULE II

THEORY OF EXTERNALITIES

Externalities
An externality is a cost or benefit of an economic activity experienced by an
unrelated third party. The origins of 'externality', comes from the Latin word 'externus'
- meaning 'outside' or 'outward'. Thus, externalities refer to situations when the effect
of production or consumption of goods and services imposes costs or benefits on
others which are not reflected in the prices charged for the goods and services being
provided. The external cost or benefit is not reflected in the final cost or benefit of a
good or service. Therefore, economists generally view externalities as a serious
problem that makes markets inefficient, leading to market failures. The externalities
are the main catalysts that lead to the tragedy of the commons.

In economics, externalities are a cost or benefit that is imposed onto a third party
that is not incorporated into the final cost. For example, a factory that pollutes the
environment creates a cost to society, but those costs are not priced into the final
good it produces. Production externalities occur when a manufacturer releases
pollution into the atmosphere during its production process. There are also
consumption externalities that occur during the consumption of a good. For example,
smokers release toxic fumes into the atmosphere that can be detrimental to the
health of those who inhale the fumes thereby creating a negative externality through
pollution.

The primary cause of externalities is poorly defined property rights. The ambiguous
ownership of certain things may create a situation when some market agents start to
consume or produce more while the part of the cost or benefit is inherited or received
by an unrelated party.

Types of Externalities

Generally, externalities are categorized as either negative or positive.

1. Negative externality

A negative externality is a negative consequence of an economic activity

experienced by an unrelated third party. The majority of externalities are negative.
Some negative externalities, such as the different kinds of environmental pollution,
are especially harmful due to their significant adverse effects. Negative externalities
are divided into production and consumption externalities.
Examples of negative production externalities include:

Air pollution: A factory burns fossil fuels to produce goods. The people living in the
nearby area and the workers of the factory suffer from the deteriorating air quality.

Water pollution: a tanker spills oil, destroying the wildlife in the sea and affecting the
people living in coastal areas.

Noise pollution: People living near a large airport suffer from high noise levels.

Some examples of negative consumption externalities are:

Passive smoking: Smoking results in negative effects not only on the health of a
smoker but on the health of other people.

Traffic congestion: The more people that use cars on roads, the heavier the traffic
congestion becomes.

2. Positive externality

Positive externality is a benefit from an economic activity experienced by an

unrelated third party. Despite the benefits of economic activities that involve positive
externalities, the externality also creates market inefficiencies. Positive externalities
can also be distinguished as production and consumption externalities.

Positive production externalities include:

Infrastructure development: Building a subway station in a remote neighborhood may

benefit real estate agents who transact properties in the area. Real estate prices
would likely increase due to better accessibility, and the agents would be able to
earn higher commissions.

Research & Development activities: A company that discovers a new technology as

a result of research and development activities creates benefits that help society as
a whole.

Examples of positive consumption externalities are:

Individual education: The increased levels of an individual's education can also raise
economic productivity and reduce unemployment levels.

Vaccination: Benefits not only the person vaccinated but other people in the
community because the probability of being infected decreases.

EXTERNALITY THEORY
Negative Externality

Much of the work we will do is with negative externalities. Consider, pollution is

modelled as a negative externality. Economists illustrate the social costs of
production with a demand and supply diagram. Consider following figure. It 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 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 Q1. 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)].
 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.
How do you know which quantity maximizes surplus?
• When looking for the market equilibrium (sometimes called the unregulated
market equilibrium), we want to select the quantity where demand = supply
or where marginal private benefit = marginal private cost. Diagrammatically, this will
happen where MPB intersects MPC. The quantity where this occurs will always maximize
market surplus.
• When looking for the social surplus maximizing equilibrium, we want to select the quantity
where marginal social benefit = marginal social cost. Diagrammatically, this will happen
where MSB intersects MSC. The quantity where this occurs will always maximize social
surplus.