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All about externalities
10th Grade

Additional Economics Flashcards




Externalities are common in virtually every area of economic activity. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.

Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption.

The study of externalities by economists has become extensive in recent years - not least because of concerns about the link between the economy and the environment.
Private and Social Costs
Externalities create a divergence between the private and social costs of production.

Social cost includes all the costs of production of the output of a particular good or service. We include the third party (external) costs arising, for example, from pollution of the atmosphere.
Social Cost = Private Cost + Externalitiy
For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the atmosphere. This creates negative externalities which impose higher social costs on other firms and consumers. e.g. clean up costs and health costs.

Another example of higher social costs comes from the problems caused by traffic congestion in towns, cities and on major roads and motor ways.

It is important to note though that the manufacture, purchase and use of private cars can also generate external benefits to society. This why cost-benefit analysis can be useful in measuring and putting some monetary value on both the social costs and benefits of production.
Market Failure and Externalities
When negative production externalities exist, marginal social cost > private marginal cost. This is shown in the diagram below where the marginal social cost of production exceeds the private costs faced only by the producer/supplier of the product. In our example a supplier of fertilizer to the agricultural industry creates some external costs to the environment arising from their production process.
Why do externalities lead to market failure?
If we assume that the producer is interested in maximising profits - then they will only take into account the private costs and private benefits arising from their supply of the product. We can see from the diagram below that the profit-maximising level of output is at Q1. However the socially efficient level of production would consider the external costs too. The social optimum output level is lower at Q2.
This leads to the private optimum output being greater than the social optimum level of production. The producer creating the externality does not take the effects of externalities into their own calculations. We assume that producers are only concerned with their own self interest.
Negative Consumption Externalities
Consumers can create externalities when they purchase and consume goods and services.

-Pollution from cars and motorbikes
-Litter on streets and in public places
-Noise pollution from using car stereos or ghetto-blasters
-Negative externalities created by smoking and alcohol abuse
-Externalities created through the mis-treatment of animals
-Vandalism of public property
-Negative externalities arising from crime

In these situations the marginal social benefit of consumption will be less than the marginal private benefit of consumption. (i.e. SMB < PMB) This leads to the good or service being over-consumed relative to the social optimum. Without government intervention the good or service will be under-priced and the negative externalities will not be taken into account. Again there will be a deadweight loss of economic welfare.
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