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Externalities GCE A-LEVEL & IB ECONOMICS

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  • ExternalitiesGCEA-LEVEL&IBECONOMICS

  • SlidesStructure

    ◦Private,ExternalandSocialCosts/Benefits◦ExternalitiesandMarketFailure◦NegativeProductionExternality◦ NegativeConsumptionExternality◦ PositiveProductionExternality◦ PositiveConsumptionExternality

  • Externalities

    Anexternalityiswhenconsumptionorproductionofagoodhasexternaleffectson3rd parties,apartfromtheconsumerandproducer.

    Thismeanssomeonenotinvolvedintheconsumptionorproductionofthegoodisaffectedpositivelyornegatively.

    Externalitiesareatypeofmarketfailureasitmisalignsthecost/benefitofconsumersorproducerswiththatofsociety’scosts/benefits,disruptingoptimalresourceallocationinthemarket.

  • DoesAnyoneRecallthisEvent?

  • ExternalitiesTounderstandthisconceptandundertakeeconomicanalysisonexternalities,weneedtolearnEconomictermsdescribingthemisalignmentofprivateandsocialbenefitsandcosts:

    Marginalprivatebenefit(MPB)isthebenefitaconsumergainsfromconsumingthenextunitofthegood.

    Marginalsocialbenefit(MSB)isthetotalbenefitsocietygainsfromconsumingthenextunitofthegood.

    Marginalprivatecost(MPC)isthecostafirmincursfromproducingthenextunit ofthegood.

    Marginalsocialcost(MSC)isthetotalcostsocietyincursfromproducingthenextunitofthegood.

  • ExternalCosts&Benefits

    MSBincludesMPBbutalsotheadditionalbenefitstosocietyofconsumingorproducingoneextraunitofthegood.Theadditionalbenefitsarecalledexternalbenefits

    MarginalSocialBenefit=MarginalPrivateBenefit+MarginalExternalBenefit

    MSCincludesMPCbutalsotheadditionalcoststosocietyofconsumingorproducingoneextraunitofthegood.Theadditionalcostsarecalledtheexternalcosts

    MarginalSocialCost=MarginalPrivateCost+MarginalExternalCost

  • ExternalitiesExample

    Theprivatecostofextractingoiltooilcompaniesislowerthanthesocialcosttosociety.Whenanoilspillhappens,manythirdpartiesareadverselyaffected(e.g.fishing&tourismindustries,wildlifeseers).

    Theoilcompaniesdonothavetopaythesethirdpartieswhenextractingtheoil.Hence,oilcompaniestendtooverproduce(extract)oildespitesocietymaypreferforthemtoproduceless.

  • MarginalBenefit

    MarginalBenefit(MB)ishowmuchutilityapersongainsfromconsumingthenextunitofthegood.

    Theutilityyougainfromconsumingagoodgraduallydecreaseswhenyouhavemoreandmoreofit.Thisiswhyyouarewillingtopayhighpricestoobtainthegoodwhenquantityislow,viceversa.

    Hence,themarginalbenefitcurveisanalogoustothedemandcurvesuchthatmoreisdemandedwhenthepriceislow.

    Price

    Quantity

    MB(D)

    P

    Q

  • MarginalCost

    MarginalCost(MC)ishowmuchitcostsaproducertosupplyonemoreunitoftheproduct.

    Ingeneral,ifthemarketpricecancoverthecostofproducingthenextunit,thenthefirm(orsociety)willsupplyit.Themarketpriceforthenextunitwillbehigherwhenmoreneedstobeproduced.

    Hence,themarginalcostcurveisanalogoustothesupplycurve,suchthatmoreissuppliedwhenthepriceishigh.

    Price

    Quantity

    MC(S)

    P

    Q

  • MaximizingNetBenefitThenetbenefitfromproducingonemoreunitofthegoodisthensimplyMB– MC.

    WhenmarketquantityisatQ1,marginalbenefitishigherthanmarginalcost.Thismeansconsuming/producingthenextunitwillincreasetotalbenefitofsociety(becausebenefits>cost).Hence,netbenefitisnotmaximised.

    MB(D)

    Price

    Output

    MB

    0

    MC(S)

    Q1 Q2

    MC

  • MaximizingNetBenefit

    Similarly,whenquantityisatQ2,marginalcostishigherthanmarginalbenefit,meaninglessshouldbeconsumed/producedtoreducelossoftotalbenefit,tomaximisenetbenefit.

    MB(D)

    Price

    Output0

    MC(S)

    Q1

    MC

    Q2

    MB

  • MaximizingNetBenefit

    Asaresult,netbenefitismaximisedatthemarketequilibriumwhereMB=MC.Itisanalogoustowheredemand=supplyinthefreemarket,whichisalsotheallocativeefficientpointthatmaximisesproducerandconsumersurplus.

    Whenthemarketisnotoperatingatequilibrium,thisphenomenoniscalledMarketFailure. MB(D)

    Price

    Output0

    MC(S)

    PE

    QE

  • ExternalitiesInmanycases,afirm’sprivatemarginalcostmaynotalwaysbealignedwithsociety’smarginalcost.Whatdoyouthinkaresomeinstancesofthis?

  • Externalities

    WecallthetheseexamplesaNegativeProductionExternalityasover-productionoftheproductleadstoanegativeeffectonthirdparties(e.g.society/others).

    Herearetheothertypesofexternalities:

    PositiveConsumptionExternalityiswhenagood/serviceisunder-consumedbecauseitsconsumptionwillbenefitthirdparties.

    NegativeConsumptionExternalityiswhenagood/serviceisover-consumedbecauseitsconsumptionwillharmthirdparties.

    PositiveProductionExternalityiswhenagood/serviceisunder-producedbecauseitsproductionwillbenefitthirdparties.

  • Externalities

    Someotherexamplesofnegativeproductionexternalities...

  • Externalities

    MPB=MSB

    Price

    Output0

    MSC

    Q2

    Inanegativeproductionexternality,thefirmincurslowercostthansocietyastheydonotneedtopayforexternalcosts(e.g.environmentalpollution).ThisisindicatedbyhavingMPContherightofMSC(remembersupplyshiftstotherightwhencostislower).

    Benefits(demand)isnotaffectedandwillstillbealigned,hencemarginalsocialbenefit(MSB)=marginalprivatebenefit(MPB).

    Q1

    MPC

  • Externalities

    MPB=MSB

    Price

    Output0

    MSC

    SocialOptimumMSC=MSB

    Q2

    Tooptimisetheirtotalbenefit,thefirmwillproducethequantityindicatedattheprivateoptimumwhereMPC=MPB(Q2).ThisishigherthanthedesiredamountofoutputforsocietyatQ1,whereMSC=MSB.

    Hence,thetotalbenefitforsocietyisnotmaximisedasMSCishigherthanMSBatQ2.Intheoilspillexample,thisisbecausethefirmdoesnotneedtopayforthenegativeconsequencesdealttothirdpartieswhenextracting(producing)oil. Q1

    MPC

    PrivateOptimumMPC=MPB

  • Externalities

    MPB=MSB

    Price

    Output0

    MSC

    MC

    Q2

    MB

    Asaresult,thereisasocialwelfarelossindicatedbytheshadedarea,duetotheover-productionofoilinthesociety’sperspective.Lessoilshouldbeproducedasthesocialcostofproducingoneunitiscurrentlyhigherthanthesocialbenefitreceived,meaningitisnotallocativeefficient.

    Q1

    MPC

  • Externalities

    MB(D)

    Price

    Output

    MB

    0

    MC(S)

    Q1

    MC

    Q2

    MC

    MB

    MPB=MSB

    Price

    Output0

    MSC

    MC

    Q2

    MB

    Q1

    MPC

    Asshownbelow,whenMSC>MPC,weareproducingatQ2,butnotattheallocativeefficientoutput(equilibriumquantity).Theshadedareaisthesocialbenefitlost.

  • NegativeConsumptionExternalitiesSometimesitishouseholdswhichconsumeparticulargoods,thatcausesanegativeexternaleffectonothers.Whatdoyouthinkaresomecasesofthese?

  • NegativeConsumptionExternalitiesCigarettesmokingoftenleadtodetrimentalhealtheffectsontheconsumer.ThistendstoincreasingcostsincurredbytheNHSandhencetaxpayers,whichisathirdparty.

    Inthecigaretteexample,thereisanoverconsumptionofcigarettesastheindividualderivesahigherbenefitfromsmokingthansocietysincetheydonotneedtopayfortheirhealthcarecosts.Hence,privatebenefitsofconsumption(MPB)ishigherthansocialbenefits(MSB)forcigarettes.

  • NegativeConsumptionExternalities

    MSB

    Price

    Output0

    MSC=MPC

    MC

    Q2

    MB

    MPB

    Costsarenotaffectedandwillstillbealigned,hencemarginalsocialcost(MSC)=marginalprivatecost(MPC).

    Finally,thereisasocialwelfarelossindicatedbytheshadedarea,asthemarketisover-allocatingtheamountofcigarettesinthemarket.Thequantitybeingtransacted(Q2)ishigherthanthemarketequilibriumquantity.Thismeansitisnotallocativeefficient.

  • Externalities

    MSB

    Price

    Output0

    MSC=MPC

    MC

    Q2

    MB

    MB(D)

    Price

    Output

    MB

    0

    MC(S)

    Q1

    MC

    Q2

    MC

    MB

    MPB

    Asshownbelow,whenMPB>MSB,weareproducingatQ2,butnotattheallocativeefficientoutput(equilibriumquantity).Theshadedareaisthesocialbenefitlost.

  • Externalities

    MSB

    Price

    Output0

    MSC=MPC

    MC

    Q2

    MB

    MPB

    Asshowninthediagram,themarketisallocatingquantityofcigarettesatQ2,butnotQE.Thismeansitisnotallocativeefficientandcausedtheshadedwelfareloss.

    Ifitwereallocativeefficient,marginalsocialcostwouldequalmarginalsocialbenefit(MSC=MSB)withquantityatQE.Thispointiscalledthesocialoptimum. QE

  • PositiveConsumptionExternalitiesWhatdoyouthinkaresomeexamplesofpositiveconsumptionexternalities?Whatgoodsgenerateapositiveeffectonthirdpartieswhenconsumed?

  • PositiveConsumptionExternalities

    MPB

    Price

    Output0

    MSC=MPC

    MC

    Q2

    MB

    MSB

    Inapositiveconsumptionexternality,consumptionofthegoodwillbringaboutpositiveeffectsonthirdparties.Thismeanstomaximisesociety’sbenefit,weneedtoconsumethegoodmore.

    Currently,thegoodisbeingunder-allocatedandunder-consumedinthemarket.Theshadedareaisthepotentialwelfaregainifconsumptionincreasesfromtheoriginalquantity(Q1)tothesocialoptimum(Q2). Q1

  • PositiveProductionExternalitiesWhatdoyouthinkaresomeexamplesofpositiveproductionexternalities?Whatgoodsgenerateapositiveeffectonthirdpartieswhenproduced?

  • PositiveProductionExternalities

    MPB=MSB

    Price

    Output0

    MPC

    MC

    Q2

    MB

    Tryexplainingthediagramofapositiveproductionexternalityyourself,givenpreviousexamplesofexternalities.

    Q1

    MSC


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