Externalities
Key definitions
external cost: a cost that is associated with an individual firm or household’s production or
other economic activities that is borne by a third party, and is not reflected in market prices
social cost: private cost plus external costs
marginal social cost: the cost to society of producing an extra unit of a good
Externalities are a common form of market failure. external benefit: a benefit that is associated with an individual firm or household’s
Peter Smith brings together the key definitions production or other economic activities that is received by a third party, and is not reflected
in market prices
needed to analyse this important topic in economic
social benefit: private benefit plus external benefits
analysis, and provides the relevant diagrams
marginal social benefit: the benefit received by society from consuming an extra unit of a good
What is an externality?
An externality arises in a market when there are costs or benefits that are external to a market
transaction, in the sense that they are incurred (or enjoyed) by a third party. This means that
they are not reflected in market prices. This leads to a misallocation of resources in society.
• The preferred allocation of resources within a market occurs when marginal social cost
(MSC) is equal to marginal social benefit (MSB).
• If MSB is greater than MSC, then an increase in consumption of an extra unit of the good
adds more to social benefit than to social cost, so society is better off. The reverse is true
where MSC is greater than MSB.
Negative consumption externalities
• When there is a negative consumption
Costs, benefits
externality, marginal social benefit (MSB) is MC
lower than marginal private benefit (MPB), as
Negative production externalities in Figure 3.
• When there is a negative production • Firms take decisions on the basis of MPB,
Costs, benefits
S (MSC) so the market settles at Q3, rather than at Q*. MPB
externality, marginal social cost (MSC)
exceeds marginal private cost (MPC), as in MPC • The shaded area represents the welfare
Figure 1. loss for society in this position. MSB
P*
• Firms take decisions on the basis of MPC, • An example is where an individual drops
P1 Q* Q3
so the market settles at Q1, rather than at Q*. litter in a public park, thus reducing the
Quantity per period
• The shaded area represents the welfare D (MSB) pleasure that others receive from it.
loss for society in this position. Figure 3 A negative consumption externality
• An example is where there is pollution
Q* Q1
caused by the production process that
Quantity per period
imposes costs on neighbouring households
that are not reflected in the costs faced by Figure 1 A negative production externality
the polluting firm. Positive consumption externalities
• When there is a positive consumption
Costs, benefits
externality, marginal social benefit (MSB) is
higher than marginal private benefit (MPB), MC
as in Figure 4.
Positive production externalities • People take decisions on the basis of MPB,
so the market settles at Q4, rather than at Q*.
Costs, benefits
• When there is a positive production MPC
externality, marginal social cost (MSC) is • The shaded area represents the welfare
MSC forgone by society in this position. MSB
lower than marginal private cost (MPC), as in MPB
Figure 2. • An example is where an individual takes
pride in their front garden, giving pleasure to Q4 Q *
• Firms take decisions on the basis of Quantity per period
neighbours and passers-by.
marginal private costs (MPC), so the market
settles at Q2, rather than at Q*. D (MSB) Figure 4 A positive consumption externality
• The shaded area represents the welfare
forgone by society in this position. Q2 Q *
• This could occur when a firm’s actions Quantity per period
reduce costs for other firms, for example EconomicReviewExtras
if the bees from a honey producer’s hives Figure 2 A positive production externality Go online for a printable pdf of this
pollinate a neighbouring farmer’s apple trees. centre spread (see back cover).
16 Economic Review November 2014 17
