Externalities

Definition of Externalities

• Occur when costs or benefits affect individuals not involved in the decision-making process.
• Types of Externalities:
  • Negative Externalities: Third-party costs.
  • Positive Externalities: Third-party benefits.

Negative Externalities

• Description: Decision or activity imposes costs on others not involved in the decision.
• Private Cost vs. Social Cost:
  • Private Cost: Cost to the decision maker.
  • External Cost: Cost imposed on others.
  • Social Cost: Sum of private and external costs.

Example: Cell Phone Use While Driving

• Private Costs: Cost of phone, usage costs, risk of accidents.
• External Costs: Increased risk to others, annoyance to other drivers.
• Result: Discrepancy between private and social cost leads to overproduction of such behavior.
• Government Role:
  • Correct market failure through laws and fines.
  • Raise cost of negative behavior to reduce occurrence.

Example: Steel Production

• Private Cost: Cost of producing steel.
• External Cost: Pollution affecting society.
• Market Equilibrium:
  • Private costs/benefits lead to equilibrium E1.
  • Social costs/benefits desired at equilibrium E2.
• Government Actions:
  • Impose taxes, fines, regulations.
  • Market for pollution credits incentivizing cleaner production.

Positive Externalities

• Description: Decisions provide benefits to others.
• Private Benefit vs. Social Benefit:
  • Private Benefit: Benefit to the decision maker.
  • External Benefit: Benefit to others.
  • Social Benefit: Sum of private and external benefits.

Example: Education

• Private Benefits: Love of learning, higher-paying job prospects.
• External Benefits: Better educated populace, economic innovation.
• Result: Underproduction in a free market due to lack of full benefit realization by private decision makers.
• Government Role:
  • Incentivize increased education through grants, loans, tax credits.

Conclusion

• Government Intervention:
  • Negative Externalities: Increase perceived costs to decision makers.
  • Positive Externalities: Increase perceived benefits to decision makers.

Next Topic: Public Goods