Overview
This lecture defines externalities and market failures, explains how they affect third parties, and introduces key cost concepts related to externalities.
Externalities
- Externalities are costs or benefits from a market activity that impact third parties not involved in the transaction.
- Negative externality example: Secondhand cigarette smoke affects bystanders negatively.
- Positive externality example: Smelling a neighbor’s food provides enjoyment to others not involved in cooking or buying the food.
- Third parties are individuals or groups not directly participating in the original market transaction.
Market Failures
- Market failure occurs when resources are allocated inefficiently, often due to externalities.
- Market failures include situations with deadweight loss or loss of efficiency.
- Other causes of market failure: excise taxes, price controls, and imperfectly competitive markets (monopoly, oligopoly, monopolistic competition).
Costs Associated with Externalities
- Internal costs: Costs paid only by the participants in the market activity (e.g., firm or consumer directly involved).
- External costs: Costs imposed on those who are not participating in the transaction.
- Social cost: Total cost to society, calculated as internal cost plus external cost.
Key Terms & Definitions
- Externality — Cost or benefit of a market activity that affects third parties not involved in the transaction.
- Negative externality — An externality that imposes a cost on third parties.
- Positive externality — An externality that provides a benefit to third parties.
- Market failure — Inefficient allocation of resources, often leading to deadweight loss.
- Internal cost — Cost of a market activity paid only by the participant.
- External cost — Cost of a market activity imposed on non-participants.
- Social cost — Combined internal and external costs, representing the total cost to society.
Action Items / Next Steps
- Review examples of negative and positive externalities.
- Be prepared to identify internal, external, and social costs in given scenarios.