Unit 1.2: Externalities
Introduction
Externalities: cost or benefit to third party resulted from the production/ consumption of a
good.
Private costs: costs that are borne by producers or consumers of a good.
Private benefits: benefits enjoyed by the producers or consumers of a good.
External costs: also known as negative externalities, are costs borne by third parties who are
neither the consumers or producers of the good.
o E.g. a person live with a smokers may suffered from second hand smoke.
External benefits: also known as positive externalities. Are benefits or gain to third parties
resulting from production or consumption of a good.
o E.g. if firms are more productive & efficient, they have lower production costs,
which, in turn, allow it to charge lower prices to consumers. So indirectly, the
consumer benefits from such advances.
Social costs = praise costs + external costs
Social benefits= private benefits + external benefits
Socially optimum level: marginal social cost =marginal social benefits
Positive consumption externalities
Positive consumption externality: these are benefits to third party as a result of
consumption of a good or service by others.
Key argument for the provision of merit goods by government.
E.g. if you take a train, it reduces congestion for other travellers.
In this case, the social marginal benefit (SMB) > private marginal benefit (PMB)
Consumers are only interested in maximising their own benefits/ satisfaction, so they will
disregard negative externalities & consume at Q1 where demand = supply (private benefit =
private cost).
However, this is socially inefficient because at Q1, social marginal cost < social marginal
benefit.
o there is under-consumption of the positive externality.
Socially optimal level of output would occur at Q2 (optimal level of output) where SMC=SMB
Negative consumption externalities
Introduction
Externalities: cost or benefit to third party resulted from the production/ consumption of a
good.
Private costs: costs that are borne by producers or consumers of a good.
Private benefits: benefits enjoyed by the producers or consumers of a good.
External costs: also known as negative externalities, are costs borne by third parties who are
neither the consumers or producers of the good.
o E.g. a person live with a smokers may suffered from second hand smoke.
External benefits: also known as positive externalities. Are benefits or gain to third parties
resulting from production or consumption of a good.
o E.g. if firms are more productive & efficient, they have lower production costs,
which, in turn, allow it to charge lower prices to consumers. So indirectly, the
consumer benefits from such advances.
Social costs = praise costs + external costs
Social benefits= private benefits + external benefits
Socially optimum level: marginal social cost =marginal social benefits
Positive consumption externalities
Positive consumption externality: these are benefits to third party as a result of
consumption of a good or service by others.
Key argument for the provision of merit goods by government.
E.g. if you take a train, it reduces congestion for other travellers.
In this case, the social marginal benefit (SMB) > private marginal benefit (PMB)
Consumers are only interested in maximising their own benefits/ satisfaction, so they will
disregard negative externalities & consume at Q1 where demand = supply (private benefit =
private cost).
However, this is socially inefficient because at Q1, social marginal cost < social marginal
benefit.
o there is under-consumption of the positive externality.
Socially optimal level of output would occur at Q2 (optimal level of output) where SMC=SMB
Negative consumption externalities
