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Understanding Externalities: Key Concept in Economics
Dive into the world of externalities and their impact on economic systems. Learn how unintended effects shape markets, influence policy decisions, and contribute to sustainable economic practices.

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Now Playing:Externalities – Example 0a
Intros
  1. Externalities Overview
  2. Externalities Overview
    Externality Definition & Types
    • Definition of Externality
    • Positive & Negative Externality
    • Positive & Negative Production Externalities
    • Positive & Negative Consumption Externalities
  3. Externalities Overview
    Private, External, Social Cost
    • Private & Marginal Private Cost
    • External & Marginal External Cost
    • Social & Marginal Social Cost
    • Marginal Social Cost (MSC) = MC + Marginal External Cost
Examples
  1. Negative externalities create a ________, and positive externalities create a __________.
    1. Benefit, benefit

    2. Benefit, cost

    3. Cost, benefit

    4. Cost, Cost

Externalities
Jump to:NotesConceptFAQsPrerequisites
Notes
Externality Definitions & Types

Externality: A cost or benefit from a production that affects the well-being of another person, but is not compensating or being compensated for what the production did.

Within externalities, there is
  1. Negative externality: this creates a cost
  2. Positive externality: this creates a benefit

Externalities are also known as spill overs onto third parties.

There are four types of externalities
  1. Negative Production Externalities: Clearing forests destroys habitat of wildlife and adds more carbon dioxide to the atmosphere.
  2. Positive Production Externalities: Beekeepers keeping bees for their honey. The positive externality would be the pollination from surrounding crops by the bees.
  3. Negative Consumption Externalities: Smoking cigarettes pollutes the air around you and imposes a health risk to others.
  4. Positive Consumption Externalities: Maintaining an attractive house can increase the market price for houses around your neighbourhood.

Private, External, Social Cost

Now lets investigate negative externality.

Private Cost of Production: cost incurred by the producer of a good or service .

Marginal Private Cost (MC) : Additional private cost gained from a one-unit increase in production of a good or service.

External Cost of Production : a cost that is not incurred by the producer but incurred by other people.

Marginal External Cost : Additional external cost gained from a one-unit increase in production of a good or service.

Social Cost of Production : Total cost to society resulting from productions made by individuals and firms.

Marginal Social Cost (MSC) : cost incurred by the entire society from a one-unit increase in production.

Effects of Negative Externalities

Suppose we have the demand curve and the private MC curve. The market equilibrium would be the intersection of those two curves.

Effects of Negative Externalities demand curve and the private MC curve

However, they are externality costs not covered by the firms, and incurred by others. Taking those into account, we graph the MSC curve.

Effects of Negative Externalities externality costs not covered by the firms, and incurred by others

Therefore, the intersection between the MSC and Demand curve is the socially optimal output.

Note: Since Q1 > Q2, we have an overproduction, thus a deadweight loss.

Private Benefit, & Social Benefit

Now lets investigate positive externality.

Marginal Private Benefit: The demand curve which does not take external benefit into account.

Marginal Social Benefit: A curve that takes all the benefits into account.

positive externality Private Benefit, & Social Benefit Marginal Social Benefit

Effects of Positive Externality

Suppose we have the demand curve (MPB) and the MSC curve. The market equilibrium would be the intersection of those two curves.

Effects of Positive Externality demand curve (MPB) and the MSC curve


However, they are externality benefit not covered. Taking the external benefit into account, we graph the MSB curve.

Effects of Positive Externality they are externality benefit not covered


Therefore, the intersection between the MSB and MSC is the socially optimal output.

Note: Since Q2>Q1, we have an underproduction, thus a deadweight loss.
Concept

Introduction to Externalities

Externalities are a crucial concept in economics, representing the unintended effects of economic activities on third parties not directly involved in the transaction. These spillover effects can be positive or negative, significantly impacting society and market efficiency. Our introduction video provides a visual overview of this important topic. In this article, we'll delve deeper into externalities, exploring their definition, various types, and far-reaching effects on economic systems and policy-making. Understanding externalities is essential for economists, policymakers, and businesses alike, as they play a pivotal role in shaping market dynamics and influencing decisions on resource allocation. By grasping the concept of externalities, we can better comprehend market failures, develop effective regulations, and work towards more sustainable economic practices. Join us as we unpack this fundamental economic principle and its implications for our interconnected world.

FAQs

  1. What are the main types of externalities?

    The main types of externalities are:

    • Negative production externalities (e.g., pollution from factories)
    • Positive production externalities (e.g., research and development spillovers)
    • Negative consumption externalities (e.g., secondhand smoke)
    • Positive consumption externalities (e.g., education benefits to society)

  2. How do externalities affect market equilibrium?

    Externalities cause a divergence between private and social costs or benefits. This leads to market inefficiency, where the equilibrium quantity differs from the socially optimal quantity. Negative externalities result in overproduction, while positive externalities lead to underproduction relative to the socially optimal level.

  3. What is the difference between private cost and social cost?

    Private cost is the direct cost incurred by a producer or consumer in an economic activity. Social cost includes both the private cost and any external costs imposed on third parties. The difference between social and private costs represents the external cost or benefit of an activity.

  4. How can governments address negative externalities?

    Governments can address negative externalities through various methods, including:

    • Imposing taxes (e.g., carbon taxes)
    • Implementing regulations (e.g., emission standards)
    • Creating cap-and-trade systems
    • Assigning property rights (Coase theorem)
    • Providing subsidies for alternatives

  5. Why is understanding externalities important for economic policy?

    Understanding externalities is crucial for developing effective economic policies because it helps identify market failures and inefficiencies. This knowledge allows policymakers to design interventions that align private incentives with social welfare, leading to more efficient resource allocation and improved overall societal outcomes.

Prerequisites

Before delving into the complex world of externalities, it's crucial to grasp several foundational concepts in microeconomics. Understanding these prerequisite topics will provide you with a solid framework to analyze and comprehend the intricacies of externalities and their impact on markets and society.

One of the key concepts to master is deadweight loss. This economic principle is essential when examining externalities, as it helps quantify the inefficiency caused by market failures. In the context of externalities, deadweight loss often manifests as the cost to society that isn't accounted for in market transactions. For instance, when considering negative externalities like pollution, the deadweight loss from underproduction of cleaner alternatives becomes apparent.

Another critical prerequisite is understanding market equilibrium. This concept forms the baseline for analyzing how externalities disrupt the efficient allocation of resources. When studying externalities, you'll frequently encounter scenarios where market equilibrium and externalities interact, leading to suboptimal outcomes. Grasping how markets naturally tend towards equilibrium will help you appreciate the distortions caused by external costs or benefits not reflected in market prices.

Lastly, familiarity with public goods is invaluable when exploring externalities. Many solutions to externality problems involve some form of public intervention or the public provision of goods. Understanding the characteristics of public goods and why markets often fail to provide them efficiently will give you insight into why externalities occur and how they might be addressed through policy measures.

By mastering these prerequisite topics, you'll be well-equipped to tackle the complexities of externalities. You'll be able to analyze how external costs or benefits affect market outcomes, evaluate the efficiency losses they cause, and consider potential solutions through both market mechanisms and public policy interventions. Remember, externalities are a prime example of market failure, and your understanding of these foundational concepts will be crucial in developing a comprehensive view of how economies function in the real world, where perfect markets are rare.

As you progress in your study of externalities, you'll find yourself constantly drawing upon these prerequisite concepts. They will serve as valuable tools in your economic toolkit, enabling you to dissect complex scenarios, predict outcomes, and propose informed solutions to externality-related problems. Whether you're examining environmental policies, public health initiatives, or technological spillovers, your grounding in deadweight loss, market equilibrium, and public goods will prove indispensable.