Externalities are the effects of the consumption or production of an economic agent on another economic agent. They are spillover effects that can be beneficial or harmful to third parties. For instance, a factory discharges its liquid waste into the nearby river; this is harmful to other users of the river and is an example of negative externalities. Another example is the benefit derived by a consumer’s neighbours when the consumer buys a smoke detector; this is a positive externality.
It is worthy of note that externalities can arise from the actions of producers or consumers. They can also be either positive or negative. There are two major categories of externalities, namely production externalities and consumption externalities. Externalities cause market failure, i.e. the inability of the market economic system to efficiently allocate scarce resources.
Private costs, external costs and social costs
The costs incurred by economic agents as a result of the actions of other economic agents are called external costs, e.g. pollution from factories, delays caused by traffic congestion, etc. These costs are usually ignored by the decision-makers in the market economy. Normally, economic agents consider only those costs they incur directly in their production or consumption decisions; these are called private costs. Examples of private costs include rent, raw material costs, labour cost, transport cost and other costs that firms pay for. If firms had considered and valued external costs, their total costs would have gone up. And the result is that they would have reduced the quantity they produce because of increased costs. This is in agreement with the theory of supply- an increase in production costs reduces supply and shifts the supply curve leftwards. The sum of private cost and external cost is social cost. Social cost represents the total cost of a decision.
Private benefits, external benefits and social benefits
There are also positive consequences of production and consumption for third parties. These are termed external benefits. External benefits are the benefits derived by one economic agent from the action of another economic agent. These are also not accounted for by private economic agents because they are not directly affected. The firm derives sales revenue from its activities; this is a private benefit. Social benefit is the sum of private benefit and external benefit.
Types of externalities
Production externalities are spillover effects arising from production. The cost incurred directly by the producer in the manufacture of an extra unit of a product is Marginal Private Cost (MPC). Marginal External Cost (MEC) is the cost to a third party that arises from producing an extra unit of a product. The value of pollution created from making every extra unit of a product is an example of MEC. The private firm in a market economy does not pay MEC but pays MPC. The summation of MPC and MEC gives Marginal Social Cost (MSC). MSC is the total cost incurred in producing an extra unit of a product. It includes both the direct and indirect costs of producing an additional unit of a product.
MSC = MPC + MEC
Cost is a major determinant of supply. If all costs (social costs) are considered, firms will supply less. But if only private costs are considered, they will supply more. The MSC curve and MPC curve are upward-sloping curves like the supply curve of a firm. MEC is the difference between MSC and MPC and is the distance between MSC and MPC curves.
MEC = MSC – MPC
Negative production externalities
Negative production externalities are the adverse effects of production on third parties. Those who are not involved in production are affected without any form of compensation. Costs are imposed on other economic agents without any consideration by the price mechanism. If there are no externalities, MSC will be equal to MPC. Graphically, the MSC will be the same as the MPC. There will be only one upward-sloping curve. When drawing production externalities curves, an assumption that the Marginal Private Benefit (MPB) curve and the Marginal Social Benefit (MSB) curve are the same could be made. Both MPB and MSB curves are downward-sloping curves like demand curves since they represent consumption externalities.
If MEC = 0,
MSC = MPC
If there are negative production externalities, MSC is greater than MPC. Graphically, the MSC curve is above the MPC curve (Figure 1 below). The free market equilibrium is at C where MPB is equal to MPC and the free market quantity is Qf. The socially optimal quantity, which is the most desirable quantity for the society, is Qo from where MSB is equal to MSC. In this case, the free market produces more than what is best for the society; therefore, there is a welfare loss (deadweight loss) represented by the area of triangle ABC. The government can use taxation to ensure that the market reduces its quantity to Qo or close to it.
If there are negative production externalities,
MSC > MPC
Figure 1: Graph showing negative production externality
Positive production externalities
Positive production externalities are the third-party benefits from production. In this case, the MPC is greater than the MSC. The cost to the society is less than the cost to the individual firm; that is to say, there are benefits the society can obtain from the actions of the producing firm. Graphically MPC is above MSC. The free market equilibrium quantity Qf (where MPB = MPC) is less than the socially optimal quantity Qo (where MSB = MSC). There is welfare to be gained (area of triangle DEF) if production can be increased to Qo. Government could grant subsidies to firms to increase their supply to Qo.
If there are positive production externalities,
MPC > MSC
Figure 2: Graph showing positive production externality
These are the benefits or costs arising from consumption. Marginal Private Benefit (MPB) is the benefit derived from consuming an additional unit of a product while the benefit to another party when one party consumes an extra unit of a product is Marginal External Benefit (MEB). The total benefit derived from an extra unit consumed is Marginal Social Benefit (MSB). MSB is the addition of MPB and MEB. Consumption externalities curves are downward-sloping like the demand curve. It is assumed that the MPC and MSC are the same.
MSB = MPB + MEB
Positive consumption externalities
These are the benefits that another economic agent enjoys as a result of the consumption activity of an economic agent. In this case, there is a positive externality and MSB is greater than the MPB. The MSB curve is above the MPB curve (Figure 3 below). The difference (distance) between the MSB and MPB is the MEB or positive externality. The free market equilibrium quantity Qf is less than the socially optimal quantity Qo. The society stands to gain welfare represented by the area of triangle GHI if the quantity consumed increases to Qo. A merit good is a good with a positive consumption externality, e.g. healthcare. The quantity consumed can be increased to socially optimal level through subsidies or direct provision by the government.
If there are positive consumption externalities
MSB > MPB
Figure 3: Graph showing positive consumption externality
Negative consumption externalities
Negative consumption externalities are the negative effects of the consumption of one economic agent on another economic agent. The MPB is greater than MSB. Therefore, the MPB curve is above the MSB curve. The product is overproduced as the free market quantity Qf exceeds the socially optimum quantity Qo leading to a welfare loss shown by the area of triangle JKL in Figure 4 below. An example is a demerit good like alcohol with a negative consumption externality.
If there are negative consumption externalities,
MPB > MSB
Figure 4: Graph showing negative consumption externality