Externalities are the costs or benefits which are external to an exchange. They are effects which are ignored by the price mechanism.
Externalities are also known as indirect costs and benefits, or as spillovers from production or consumption of a good or service. In effect, external costs are negative externalities and external benefits are positive externalities.
External costs may occur in the production and in the consumption of a good or service. An example of an external cost in production is a chemical firm polluting a river with its waste. This cause an external cost to the fishing and water supply industries. Fish catches may be reduced and it may become very expensive to purify water to meet the European Commission safety standards.
An example of external costs in consumption is a person is a person smoking tobacco, polluting the air for others. The effect is to cause passive smoking, where non-smokers may suffer the same illnesses as smokers.
In a free market, producers are only concerned with the private costs of production. These include wages for workers, rent of buildings, payment for raw materials, machinery costs, electricity and gas costs, insurance, packaging and transport costs. Private costs may also refer to the market price that a consumer pays for a good or service.
By adding private costs to external costs we obtain social costs. This means that external costs are the difference between private costs and social costs. The marginal private cost and marginal social cost curves often diverge, indicating that external costs increase disproportionally with output. However, it is possible that external costs per unit remain constant, in which case the marginal private cost and marginal social costs are drawn parallel to each other. The relationship between private cost, external cost and social cost is shown below.
[diagram on page 38]
Note that the Edexcel specification focuses on diagrammatic analysis of externa; costs in production.
External benefits occur in the production and consumption of a good or service. An example of an external benefit in production is the recycling of waste material such as newspapers, glass and tins. It has the benefit of reducing the amount of waste disposal for landfill sites, as well as re-using materials for production. It helps to promote sustainable economic gorwoth.
An external benefit in consumption is the vaccination of an individual against various deseases. It reduces the possibility of others catching the deseases who come in contact with the vaccinated individual.
In a free market, consumers are only concerned with the private benefits or utility from consuming a goo or service. Economists assume this can be measured by the price that consumers are prepared to pay for the good or service. Private benefits may also refer to the revenue that a firm obtains from selling a good or service.
By adding private benefits to external benefits we obtain social benefits. this means external benets are the difference between private benefits and social benefits. The marginal private benefit and marginal social benefit curves often diverge, indicating that external benefits increase disproportionally with output consumed. However, it is possible that external benefit per unit consumed will remain constant – the the marginal social benefit an the marginal private benefit curves are drawn parallel to each other.
[diagram on page 39]
The free-market equilibrium
The supply curve for a firm is the marginal private cost curve (MPC). The addition of all MPC curves in the market for a particular good or service will form the market supply curve.
The demand curve for consumers is the marginal private benefit curve (MPB). Economists assume that it is possible to measure the benefit obtained for consuming a good by the price people are prepared to pay for it. As an individual consumers more unit of good, the marginal benefit (marginal utility) will fall. This is why the demand curve slopes downwards from left to right. The addition of all the consumers’ MPB curves for a particular good or service will form the demand curve.
Market equilibrium occurs where marginal private benefit equals marginal private cost.
The socially optimal equilibrium
The socially optimal level of output or price for a good or service occurs when marginal social costs equals marginal social benefit. The social cost of producing a the last unit of output equals the social benefit from consuming it. When the socially optimal level is reached in a market, welfare is maximised.
External costs and the triangle of welfare loss
[diagram on page 40]
The free market ignores negative externalities. However, adding external costs on to the production of a good or service, such as the production of chemical hoods, the socially optimal price is at OP1, and quantity OQ1. When external costs are ignored there is under-pricing, and over-production. There is an excess of social costs over social benefits for the marginal output between Qe and Q1.
The marginal social cost of the output slice o QeQ1 is QeWYQ1m which exceed the marginal social benefit of the output QeXYQ1. The excess social costs over social benefits is shown by the triangle XWY. This is the area of welfare loss to society, the market has failed since negative externalities are ignored.
External benefits and the triangle of welfare gain
The free market ignores positive externalities. However, adding external benefits on to the consumption of a good or service, suc as the consumption of vaccinations, causes the demand curve to shift to the right and become the marginal social benefit curve, shown in the diagram below.
Assuming there are no external costs in the consumption of vaccinations in a free market, the socially optimal price in the consumption of vaccinations is at OP2, and quantity is at Q2. When external benefits are ignored, there is under-pricing and under-production. There is an excess of social benefits over social costs for the marginal output between Qe and Q2. Thus, by raising output from 0Qr to 0Q2, welfare could be increased.
The marginal social benefit of the output slice QeQ2 is QeMTQ2, which exceeds the marginal social cost of this output QeZTQ2. The excess of social benefits over social gains is shown by the triangle MTZ. This is the area of welfare gain to society; the market has failed since these positive externalities are ignored.
[diagram on page 41]