Externalities occur when costs or benefits accrue to a person or persons who are not involved in the decision-making process. Note that externalities can involve either third-party costs, this would be a negative externality, or third-party benefits, this would be a positive externality. Let's address each of these in turn. Negative Alternative externalities occur when a decision or activity imposes costs on anyone not involved in making that decision. Think of it this way.
Every decision involves some cost to the decision maker, that's the private cost of your choice. But sometimes the decision imposes costs on others as well, which would be the external cost. Social cost, then, is the total cost to all members of society, or the sum of the cost to the decision maker, which is the private cost, and to others, external cost. What this means is that if a decision imposes any kind of external cost, then the social cost will exceed the private cost. Think about this.
Do you think that too many people use their cell phones while driving or too few? Well, why do you think that is? The answer lies with this notion of externalities.
Look at it this way. When you are deciding whether or not to get on your cell phone while you're driving, what are the private costs, i.e., the cost to you? the decision maker.
Perhaps the cost of buying a cell phone in the first place, or maybe the minutes you'll be using, or the cost of sending a message. It might even occur to you that you're increasing the likelihood of you getting into an accident. Now, are there any costs to other people, people who have no control over your decision to use your phone while behind the wheel? What about the increased risks to them, or even just the annoyance of you driving like an idiot because you're on the phone?
These are the external costs, or the costs you impose on others with your behavior. In the end, this discrepancy between the cost to you and the cost to society, which is the sum of the private and the external cost, leads to overproduction. if you will, of people driving while on their cell phones. Why? Because we're all rational decision makers, using the cost to us and the benefits to us to make our decisions.
Very rarely do you find someone who includes costs to others when weighing a private decision. Essentially, you make the decision to be on the phone while driving because you consider only part of the cost, the cost to you, with negative externalities because the private decision is based on costs to you. that are too low from society's standpoint, the behaviors or products are overproduced from society's view. This market failure provides a role for the government to correct the market, i.e. bring the production back to the socially optimal level. In the case of cell phones, this is most often done by putting laws in place that ban such behavior while driving and have hefty fines attached if you're caught.
This effectively raises the cost of engaging in such behavior and thus decreases the cost decreases the amount of the behavior that occurs. The same idea would apply to, say, a steel factory. There's a certain private cost of producing steel.
I'll assume that on the benefit or demand side, private and social are the same for now. But the production of steel also results in pollution, a cost to others in society. This means that the marginal social cost is greater than the marginal private cost.
And if steel is left to its own devices, the steel market market will be based on private costs and private benefits yielding the price and quantity associated with equilibrium E1. What would society rather see? The socially optimal outcome would be based on social costs and social benefits, or equilibrium E2.
Notice this means society would like to see less production, meaning less pollution, and would be willing to pay a higher price to do so. you This is where the government comes in. What is the government's solution to a negative externality? Simple. Get the decision maker to internalize the external effect.
Since the problem arises from the decision maker using costs that are too low, you need to somehow impose some additional cost so the decision becomes based on the level of social cost. This could be done by way of taxes, fines, regulation, or cleanup fees. Or, However, in the case of pollution, there's now a market for credits that allow you to pollute. If you're a clean producer, you'll have unused credits you can sell, which is an incentive for cleaner production.
If you create a lot of pollution, you'll need to acquire extra credits to continue continue producing, which is also an incentive to cut back on pollution production. What about positive externalities. Just as you can make choices that impose costs on others, you can also make choices that result in benefits to others. If this is the case, then social benefits equal the private benefits, benefits to the decision maker, plus external benefits, benefits to others. In the case of a positive externality, social benefits exceed private benefits.
Take education, for example. You decided to continue your education. Why is that? What are the benefits to you of making this decision?
It might just be the love of learning or because you know that education means a better, higher-paying job in the future. But what about society? Society as a whole benefits from having a better educated populace.
Highly educated, highly skilled workers tend to be innovators, which helps keep our economy moving forward. All of this is good, except for the fact that in a free market, education will be underproduced. This is true of any positive externality.
Why? Because the private decision maker doesn't see the full benefit of education that society sees, so not as much education is produced. For the consumer of education, there's a certain private benefit. I'll assume private cost and social cost are going to be the same. Decision making based solely on private costs and benefits results in equilibrium at E1.
Society as a whole sees a greater benefit. If the equilibrium were based on social costs and social benefits, equilibrium would occur at E2. Society desires a greater level of education and is willing to pay more to achieve it. From a social standpoint, in a free market, education will be underproduced. What's the government's solution to a positive externality?
Well, get the decision maker to internalize the externality. effect. Sounds familiar, doesn't it?
Except that with a negative externality, we had to try to get the decision maker to see higher costs. With a positive externality, the government needs to somehow make the decision more beneficial to the private decision maker. In the case of education, the government may provide grant money, low interest loans, or tax credits in order to provide added incentive to get more education. Next time? Public Goods.