Negative Externalities 2022.pptx

http://www.bized.co.uk
Copyright 2006 – Biz/ed
Positive and Negative
Externalities
• An externality is the
uncompensated impact of one
person’s actions on the well-being
of a third-party (bystander)
• Adverse impact Negative externality
• Beneficial impact Positive externality
• Buyers and sellers neglect external effects of
their actions therefore the market equilibrium
is not efficient when there are externalities

• Externalities cause markets to be
inefficient, and thus fail to
maximize total surplus.

Private & Social Cost
• Private cost: the cost producing
the good paid by the firm
• Social cost: the cost to everyone in
society, including people who do
not produce or consume.
• Social cost = private cost +
external cost

• Costs and benefits in production:
• External costs in production: where MSC =
MSB – MPC
– e.g. air and water pollution, congestion, housing
development on green belt areas, destruction of
hedgerows and wildlife, noise, pollution, anti-social
behaviour, crime
• External benefits in production – where MSC <
MPC
– e.g. human resource development, research and
development in industry
Positive and Negative Externalities

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Consumption and production can both
create negative externalities

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Private and social costs

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Private costs
Financial
Health
External costs
External benefits
Private benefits
A divergence
between private and
social costs and
benefits?

EXTERNALITIES AND MARKET INEFFICIENCY
• Negative consumption Externalities
• Automobile exhaust
• Cigarette smoking
• Barking dogs (loud pets)
• Loud stereos in an apartment building

Negative production externality
• When a firm's production
reduces the well-being of
others who are not
compensated by the firm.
• Private marginal cost (PMC): The
direct cost to producers of
producing an additional unit of a
good.

EXTERNALITIES AND MARKET INEFFICIENCY
• Negative Production Externalities
• Factory emissions
• Musical Festivals

Private costs
Financial
Health
External costs
External benefits
Private benefits
A divergence between
private and social costs
and benefits?

Private and Social Costs
• Private Costs
• Are paid only by the producer or consumer
concerned
• They are internal costs of production or consumption
• Social Costs
• Social Cost = Private Cost + External Cost
• Negative externalities add to social costs or reduce
social benefits
• We assume that the consumer and/or producer does
not take external costs into account when making
decisions
• This can lead to a misallocation of resources
(causing a loss of allocative efficiency)
• This means that social welfare is not maximized - a
cause of market failure

Social cost
Private Costs + External cost = Social Costs
Cost to
individual
consumers or
firms of their
economic
activity
Cost to others of
individual
consumers or
firms economic
activity
Total cost to
society of a
given
economic
activity
Cost to first
parties -
individuals
Cost to third
parties - others
Total Cost to
society -
everyone

Negative Production Externality
• When producing a good causes a
harmful effect to a third party.
Therefore the social cost is greater
than the private cost.

Negative Externalities & Market Failure
Private Optimum – where MPC = MPB
Costs
Benefits
Output (Q)
PMB = SMB
PMC
Qp
Assuming no negative
externalities from
consumption

Add in the External Cost
Costs
Benefits
Output (Q)
Private benefit =
social benefit
Private
Cost
Social
Cost
Qp

Add in the External Cost
Costs
Benefits
Output (Q)
PB = SB
PC
SC
Qp
External Cost

The Social Optimum Output
Costs
Benefits
Output (Q)
PB = SB
PC
SC
Qp
External Cost
Qs

Summary
• Because of the external costs the social marginal
cost is greater than the private marginal cost.
• In a free market, producers ignore the external
costs to others. Therefore output will be at Q1
(where Demand = Supply).
• This is socially inefficient because at Q1 – SMC>
SMB
• Social efficiency occurs at Q2 where Social
marginal cost = Social marginal benefit
• The red triangle is the area of deadweight welfare
loss. It indicates the area of overconsumption
(where SMC is greater than PMC)

Negative externality of
consumption
• This occurs when consuming a
good causes a harmful effect to a
third party.
• In this case, the social benefit is
less than the private benefit.

Negative Consumption Externality

Negative Consumption Externality
• In a free market, we get Q1 output.
• But at this output, the social
marginal cost is greater than the
social marginal benefit.
• The red triangle is the area of dead-
weight welfare loss.
• Social efficiency occurs at a lower
output (Q2) – where social marginal
benefit = social marginal cost.

Explaining the market failure
• The efficient allocation of resources
requires output to be increased up to the
point where social benefit equals social
cost.
• In a free market firms only take into
account the private costs of their
production.
• Given negative externalities - such as
pollution - private and social costs
diverge.
• An unregulated (free) market
consequentially overproduces the good.

• Costs and benefits in consumption:
• External costs in consumption –
where MSB < MPB
– e.g. passive smoking, litter, noise,
anti-social behaviour
Negative Externalities

• External costs – socially efficient
output is less than current output
• External benefits – socially
efficient output is greater than
current output
• Socially efficient output is where
MSC + MPC = MSB + MPB

• Weighing up the costs and benefits
• Benefits from production of
chemicals/pharmaceuticals and energy
• Costs of generating these products/services
Copyright: Karoly Feher and Drew Broadley, stock.xchng

Negative Externalities 2022.pptx

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