Lecture Notes: Negative Externalities

Introduction

• Negative Externalities: Costs imposed on third parties due to actions by others.
  • Two types:
    • Production-based: Costs occur during production by firms.
    • Consumption-based: Costs occur during consumption by consumers.

Negative Externalities in Production

• Definition: Costs to third parties from production activities.
• Examples:
  • Air Pollution: From metal, textile, or chemical production, impacting local residents.
  • Resource Depletion: Impacts future generations by reducing resources.
  • Resource Degradation: Waste pollution affects local water sources.
  • Deforestation: Affects local villages relying on forests.
• Diagram Explanation:
  • Marginal Social Cost (MSC) > Marginal Private Cost (MPC)
  • Social Costs = Private Costs + External Costs
  • Market Allocations:
    • Private Optimum: Where MPC equals MPV, leading to overproduction/overconsumption.
    • Social Optimum: Where MSC equals MSB.
• Welfare Loss:
  • Misallocation leads to welfare loss represented by a triangle pointing to the social optimum.
  • Analysis:
    • Firms ignore full social costs due to self-interest.
    • Results in resource misallocation and inefficiency.

Negative Externalities in Consumption

• Definition: Costs to third parties from consumption activities.
• Examples:
  • Smoking: Causes passive smoke inhalation risks to bystanders.
  • Alcohol Consumption: Impacts health services and police due to related incidents.
  • Sugary Drinks/Fast Food: Increases health costs due to obesity.
• Diagram Explanation:
  • Marginal Social Benefit (MSB) < Marginal Private Benefit (MPB)
  • Negative external benefits lead to a lower MSB compared to MPB.
  • Market Allocations:
    • Private Optimum: Where MPV equals MPC.
    • Social Optimum: Where MSB equals MSC.
• Welfare Loss:
  • Overproduction and overconsumption are shown by a triangle pointing to the social optimum.
  • Analysis:
    • Consumers ignore full social benefits only considering private benefits.
    • Leads to resource misallocation and loss of societal welfare.

Conclusion

• Negative externalities cause misallocation of resources leading to welfare losses.
• Importance of addressing externalities to achieve social optimum and efficiency.
• Next topic: Positive externalities.