7.11 - Externalities of Consumption & Production
The concept of externalities
Externalities are spillover effects that impact third parties not directly involved in a transaction or economic activity. They lead to market failure, resulting in a misallocation of resources and creating deadweight welfare loss.
Key technical relationships in externality analysis
- Marginal external cost (MEC) - The additional cost imposed on third parties.
- Marginal social cost (MSC) - The total cost to society, including private and external costs.
- Marginal private cost (MPC) - The cost borne by the producer.
- Marginal external benefit (MEB) - The additional benefit provided to third parties.
- Marginal social benefit (MSB) - The total benefit to society, including private and external benefits.
- Marginal private benefit (MPB) - The benefit received by the consumer.
- Social optimum output - The efficient level of output where MSB equals MSC.
Negative production externalities
Negative production externalities arise when the production of goods or services harms third parties not involved in the process. These externalities cause overproduction above the socially optimal level.
Features of negative production externalities
- Impact on third parties - Production activities create spillover costs, such as a factory releasing harmful chemicals into a nearby waterway, which damages the local ecosystem and affects residents' health.
- Overproduction - The market produces more than the socially optimal level.
- Graphical representation - The MSC curve lies above the MPC curve.
- Result - Deadweight welfare loss.
Positive production externalities
Positive production externalities occur when the production of goods or services generates benefits for third parties beyond those directly involved. This leads to underproduction in the market.
Features of positive production externalities
- Benefits to third parties - Production creates spillover advantages, for example, a research laboratory developing new agricultural techniques that enhance productivity not only for their clients but across the entire farming sector.
- Underproduction - The market produces less than the socially optimal level.
- Graphical representation - The MSB curve lies above the MPB curve by the value of MEB.
- Result - Deadweight welfare loss from underproduction.
Negative consumption externalities
Negative consumption externalities happen when the consumption of goods or services imposes costs on third parties who are not part of the consumption. This results in overconsumption relative to the social optimum.
Features of negative consumption externalities
- Impact on third parties - Consumption activities create spillover harms, such as people attending a concert generating noise pollution that disturbs nearby residents who are not at the event.
- Overconsumption - The market equilibrium exceeds the socially optimal level.
- Graphical representation - The MSB curve lies below the MPB curve by the value of MEC.
- Result - Deadweight welfare loss from overconsumption.
Positive consumption externalities
Positive consumption externalities arise when the consumption of goods or services provides benefits to third parties beyond the direct consumers. This causes underconsumption in the market.
Features of positive consumption externalities
- Benefits to third parties - Consumption generates spillover gains, for instance, individuals receiving higher education who contribute to increased innovation and productivity in the broader economy, beyond their personal benefits.
- Underconsumption - The market level of consumption is below the social optimum.
- Graphical representation - The MSB curve is above the MPB curve by the value of MEB.
- Result - Deadweight welfare loss from underconsumption.