MRG -Externalities Lesson

Externalities Lesson

Up to this point, all benefits and costs presented in the market have been restricted solely to the participants directly involved in the consumption and production of the good/service. However, as you can probably guess, there are many interactions that impact those not directly involved in the market transaction. This situation is said to create an externality. Externalities result in deadweight loss because a level of production and consumption occurs that is not equal to the socially optimal level (where MSB and MSC). An externality is a situation in which a market transaction impacts a third party. The impact can be either positive or negative. To evaluate these cases, we must refine our view of marginal benefit and marginal cost.

Marginal Benefit: Marginal benefit can be broken down into private benefit and social benefit. When consuming a good, the private benefit is the benefit that is received by the individual partaking of the consumption. If a good produces positive spillover effects (positive externality), then members of society benefit from the person consuming the good, also. Marginal social benefit would include marginal private benefit plus the amount of the positive externality. That is to say, MSB > MPB when a positive externality exists. In the face of no externality, MSB = MPB.  

Marginal Cost: Marginal cost can be broken down into private cost and social cost. When consuming a good, the private cost is the cost of producing the good. If a good produces negative spillover effects (negative externality), then members of society are harmed by the person consuming the good. Marginal social cost would include marginal private cost plus the amount of the negative externality. That is to say, MSC > MPC when a negative externality exists. In the face of no externality, MSC = MPC.

Externalities Video

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Positive Externalities

A positive externality occurs when the production and consumption of a good creates positive spillover effects on third parties. That means people not directly involved in the transaction receive some benefit. In this case, the Marginal Social Benefit (MSB) is greater than the Marginal Private Benefit (MPB). An example of a good that produces positive externalities is childhood immunizations. Since this topic has been the center of many heated debates in recent times by medical professionals, celebrities, and parents it seems a relevant illustration.

Immunizations are seen as producing both private and social benefits. The private benefit is obviously seen in that a child immunized against chickenpox is less likely to acquire the disease. The social benefit occurs because any child immunized against chickenpox is one less potential transmitter of the disease. That benefits everyone in society - those who have been immunized and those who have not. If the marginal social benefit is the sum of marginal private benefit plus the positive externality, then the marginal social benefit is greater than the marginal private benefit. The graph below shows this: 

Society would like to see more of this good produced and consumed than would result if only private benefit was considered. That is to say, a good that produces positive externalities results in less than the socially optimal level of production/consumption. Too little of the good is produced to satisfy society. Deadweight loss is the result of this inefficient level of production. Because too little of the good is being produced (compared to the socially optimal level of production), the deadweight loss appears to the left of the intersection of MSB and MSC.  

Most commonly, the government will correct a positive externality through the use of subsidies. If you remember, a subsidy is a payment that encourages the production or consumption of a good/service. In the case of immunizations, the government subsidizes the cost to the consumer with the result being an increase in the number of children receiving the immunization. The shots are offered at the local health departments at reduced rates. This is seen as shifting the MPB curve to the right until the socially optimal level of consumption is taking place. To correct a positive externality, more of the good should be produced.

Negative Externalities

A negative externality occurs when the production and consumption of a good creates negative spillover effects on third parties. That means people not directly involved in the transaction incur some type of cost. In this case, the Marginal Social Cost (MSC) is greater than the Marginal Private Cost (MPC). An example of a good that produces negative externalities is smoking. This has also been a hot topic in recent history, so let's evaluate the externality associated with the consumption and production of cigarettes.  

Cigarettes are seen as producing both private and social costs. The private cost is obviously seen in the marginal cost incurred by the company when it produces the good. However, the social cost of producing cigarettes is far greater than just the cost of production. The social cost occurs because people who do not smoke are negatively impacted by others smoking. Remember, the effects of secondhand smoke result in health problems that require medical treatment, decrease the quality of the environment, and decrease the quality of life. When this negative externality is figured into the "costs" of cigarettes, it results in a marginal social cost curve that lies to the left of the marginal private cost curve. The graph below shows this.  

Society would like to see less of this good produced and consumed than would result if only private costs were considered. That is to say, a good that produces negative externalities results in more than the socially optimal level of production/consumption. Deadweight loss is the result of this inefficient level of production. Because too much of the good is being produced (compared to the socially optimal level of production), the deadweight loss appears to the right of the intersection of MSB and MSC. 

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