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
- Negative externality: this creates a cost
- Positive externality: this creates a benefit
Externalities are also known as spill overs onto third parties.
There are four types of externalities
- Negative Production Externalities: Clearing forests destroys habitat of wildlife and adds more carbon dioxide to the atmosphere.
- Positive Production Externalities: Beekeepers keeping bees for their honey. The positive externality would be the pollination from surrounding crops by the bees.
- Negative Consumption Externalities: Smoking cigarettes pollutes the air around you and imposes a health risk to others.
- 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](
https://dmn92m25mtw4z.cloudfront.net/img_set/econ1-11-1-x-0a/v1/econ1-11-1-x-0a-858w.jpg)
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](
https://dmn92m25mtw4z.cloudfront.net/img_set/econ1-11-1-x-0b/v1/econ1-11-1-x-0b-841w.jpg)
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](
https://dmn92m25mtw4z.cloudfront.net/img_set/econ1-11-1-x-0c/v1/econ1-11-1-x-0c-806w.jpg)
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](
https://dmn92m25mtw4z.cloudfront.net/img_set/econ1-11-1-x-0d/v1/econ1-11-1-x-0d-862w.jpg)
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](
https://dmn92m25mtw4z.cloudfront.net/img_set/econ1-11-1-x-0e/v1/econ1-11-1-x-0e-911w.jpg)
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.