As we've seen, markets usually work very well at maximizing the gains from trade. Exchange happens as long as the value to consumers exceeds the cost to producers. You've heard me say it before, gains from trade.
But what happens if someone other than the consumers and producers is affected by the exchange? These are called externalities. There are costs or benefits that affect someone not directly involved in the consumption or production of a good. Externalities can be negative or positive, and we'll see examples of both. To start, we'll focus on negative externalities, in which there are additional costs other than just those borne by producers and consumers.
The classic example is pollution. For instance, when you use electricity, you get a benefit. The lights are on, the AC is running, you can surf the web.
And you pay a cost to the utility company for your usage. They produce the electricity covering their costs. But they also produce pollution, which has negative health effects on, say, people who live downwind of the power plant. Those people aren't compensated, neither by you nor the electric company, for the impact on their health. That's an externality.
Another good example is that of antibiotic use. Antibiotics are valuable and important. They can make you better, but their use also increases the likelihood of antibiotic-resistant diseases. The next person who gets sick might be much worse off than they otherwise would be because someone else was prescribed antibiotics. Externalities don't have to be big fancy examples like pollution and antibiotics.
Your roommate's loud music. provides them with a benefit but also imposes a cost on you. Their decision about how much music to listen to reflects their costs for the music itself, for the equipment and electricity to play it, but may not reflect the cost that you pay from being unable to concentrate or just having to put up with their terrible tastes. To get at this question, we need to think about private costs and private benefits versus social costs and social benefits.
The private cost is the cost borne by the producer of the good, say the cost of producing electricity or a hamburger or anything else, to the producer themselves. That's all of the things that the producer is considering when making their decision. Similarly, the private benefit is the value received by the consumer themselves, their willingness to pay.
On the other hand, social costs are the total cost of producing the good, including any external cost, like say pollution. And the social benefits are the total benefits of producing the good, including any possible external benefits, which we'll discuss in the next video. So, let's dive into an example focusing on the intuition. Let's stick with your roommate's loud music, though we could easily apply this approach to any negative externality.
So, I've got hours of loud music. the quantity on the x-axis and the price or value in dollars on the y-axis. Your roommate has a demand for loud music, a willingness to pay for each hour.
This is their demand, their marginal private benefit. This tells us how much they value each additional hour of loud music. Remember, that's exactly what a demand curve is.
What's the most you're willing to pay for each additional unit? Meanwhile, the supply curve is, of course, the marginal private cost. How much does each additional hour cost? Marginal Private Cost.
Your roommate makes a decision about how many hours of loud music to consume by comparing how much each additional hour benefits them to how much each additional hour costs them. And they'll consume where the marginal private benefit of loud music equals their marginal private cost, where the enjoyment they get from another minute of music equals the cost of it. So, let's say...
that that point is six hours of loud music every day. Ugh! For your roommate, that's the private equilibrium.
This right here is the private equilibrium. But that doesn't take into account the marginal external cost. That is the impact of the music that the music has on you and maybe your neighbors.
Let's say that every hour of loud music causes you six dollars of discomfort. The marginal social cost, the true cost, combining the cost of your roommate and the cost imposed on you would be the marginal private cost plus that marginal external cost or marginal external damage. So we're going to draw that here.
This is the marginal social cost and it equals the marginal private cost plus the marginal external cost or marginal external damage. The marginal social cost is above the marginal private cost curve. By how much? The amount of the external damage. Marginal external cost.
or marginal external damage. So for all of society including your roommate, the optimal point, the social equilibrium, is where marginal benefit equals marginal social cost. That amount is lower, let's say it's right here, at four hours.
So what's the damage if your roommate is over consuming loud music ignoring the toll it takes on you? At the fourth hour marginal social cost equals their benefit but if they consume another hour the cost to them is still below their benefit. This is their marginal private cost, this is their marginal private benefit. But their marginal benefit is less than marginal social cost.
They keep consuming until their marginal private benefit equals their marginal private cost. But the social cost of each one of those hours is greater than the benefit. The total loss of surplus from your roommate over consuming is this triangle here. I'll fill it in just a bit.
This triangle here is dead weight loss. This is the cost to society that is your room, the cost of the society that is your room, from ignoring the negative externality. These are hours of music that should not have happened because the marginal benefit from them was less than their marginal social cost.
Now notice I didn't say that your roommate should stop listening to music altogether because it bothers you. Your roommate still gets a benefit from listening to music and we have to account for that. In the same way, we don't say that there shouldn't be any production of electricity because a byproduct of it is pollution. We just say that we need to account for the external costs. It's really important to understand that not every outcome of an exchange has externalities.
Only those that have impacts outside of the market have externalities. Now, here's what I mean. If demand for tacos increases dramatically, we know that the price will go up.
It's tempting to say that other people buying more tacos has imposed an externality on me because I now have to pay a higher price than I otherwise would have. But this does not create a market inefficiency the way that a true externality does. There's no overconsumption.
Marginal benefits still equals marginal cost. There's no external damage. When a price correctly reflects the impact of market transactions, there's no inefficiency. But when there are things left out of the price, like the pollution example at the start of this video, the market might not reach the socially efficient outcome.