Hi everybody, negative exonerties are costs on third parties as a result of the actions of a separate agent. There are two kinds of negative exonerties, they can occur in production, when firms are producing something, or in consumption, when consumers are consuming something. Let's look at negative actualities in production first. So the definition is in red.
These are cost to third parties as a result of the actions of producers. So producers are producing something and third parties are suffering the costs. Third parties are individuals or economic agents who have got nothing to do with the activity or the transaction taking place.
In this case, they've got nothing to do with the production itself, but they are suffering a cost as a result of the production. So good examples could be air pollution. So if firms are producing metals or textiles or chemicals and there is air pollution as a by-product, local residents could be the third party that suffer from respiratory problems, greater risk of lung cancer. Resource depletion, so if resources are depleted.
it may be future generations of the third party. They suffer from a loss of income. They suffer from not being able to consume the goods and services made out of those resources. Maybe resource degradation, so as a by-product, if waste is being produced and is dumped in, let's say, a local river, third parties could be local residents again who maybe drink from that river or maybe bathe in the river or play water sports on the river.
So they suffer in that regard from a greater risk of disease, maybe a greater risk of death. And deforestation, third parties could... again be villagers, villagers living near the forest who use the forest for food sources, for water sources. Maybe they suffer because there is a greater risk of flooding now. So these are some good examples for you.
On a diagram, how do we show the impact of the negative externality in production? Well, marginal social cost is going to be greater than the marginal private cost. Remember our equation for social cost. There are private costs plus external costs. So here, clearly there are external costs on there as a result of production.
There are external costs, so that figure is going to be positive, which means that social cost is greater than private cost. Remember, if we're working in production, it's the cost curve that's going to have a difference, where there is going to be a problem. The benefits curve is to do with consumption, so there are no issues there.
The issue is with costs, and because external costs are positive, the social cost is going to be higher than the private cost. So on a diagram, it's going to look like this. The marginal private cost is going to be there, but the marginal social cost is going to be greater.
No issue in consumption at all, so we can label this MPB, which equals MSB, which equals demand. The market will allocate resources at the private optimum, which is where MPC equals MPB. That gives us Q1 and the price of P1. But the social optimum, which is allocative efficiency, occurs where MSC equals MSB. So that's Q star, and that's P star.
So because there is a difference between social cost and private cost... The market is allocating resources at the wrong level here. There's the misallocation of resources.
And because, in this case, there is an overproduction and overconsumption, there is a welfare loss. And the welfare loss is this triangle here. And I'll give you a trick, first of all, of how to get the welfare loss right every time.
It's always the triangle that points towards the social optimum. That's a great trick for you to use here. And there's the triangle, clearly pointing towards the social optimum.
The other way of working it out is go to the... quantity at the private optimum and let that quantity work out. Social cost and social benefit.
Social cost is way up here, social benefit is there. So for all of the units being produced beyond Q-star, social cost is greater than social benefit, clearly. We're not maximising net social benefit here and therefore allocative efficiency is not occurring.
There is a misallocation of resources. When it comes to analysis, what kind of things will you be saying? You'll be starting by saying that firms are ignoring the full social cost.
because of self-interest. They only consider their private cost. As a result, the market allocates resources at Q1 and P1, which is the private optimum, instead of the social optimum. The end result is an overproduction.
You can clearly see here an overconsumption as a result. The price is too low. That's another issue here at P1 as opposed to P star.
P1 only is accounting for the private cost and not the full social cost, which includes the external cost. That just makes the whole problem worse. It encourages more consumption of these goods.
and then makes overproduction and overconsumption issues more of an issue. The end result we see is a misallocation of resources and allocative efficiency culminating in a welfare loss. Let's now look at negative externalities in consumption. Negative externalities in consumption are just costs to third parties as a result of the actions of consumers. So for example, consumers might be smoking and there might be an impact on third party bystanders who inhale the passive smoke and a greater risk of lung cancer or...
suffer respiratory problems. Those who excessively drink alcohol, third parties could be health services, police services that have to deal with treating them or dealing with the crime as a result of their actions. Excessive sugary drink or fast food consumption can have a significant cost on the health service again. extra cost of treatment as a result of obesity related issues. It could be a negative impact on employees who have to suffer lost productivity or days missed from work.
The same thing can be said for excessive alcohol consumption. We get the idea of negative externalities in care. consumption.
On a diagram, what do we draw? Well, the issue here is with the benefits curves. The marginal social benefit will be less than the marginal private benefit, and that's because there are negative external benefits here as a result of consumption.
So when consumers are consuming, there are negative impact on third parties, so the external benefit part of the social benefit equation is going to be negative here, which means on a diagram, we're going to have this. No issues in production at all, so we can say that MSC equals... MPC, which equals supply.
No problem in production. The issue is in consumption. Private benefit is there, but social benefit is lower. There's the marginal social benefit.
The market would allocate scarce resources at the private optimum, which is here at Q1 and P1, whereas society would like resources to be allocated at the social optimum, which is where MSB equals MSC. That's a Q star, and that's a P star. You have a misallocation of resources right there. much is being produced here, an overconsumption and therefore an overproduction.
Again, if there is allocated inefficiency, there is going to be a welfare loss. The welfare loss can be seen here. Remember, it's just the triangle that points to the social optimum, but we could be more specific here. At Q1, you can see that social cost is up there, but social benefit is down there. So all of the units being produced beyond Q star are being produced at higher social cost than social benefit.
That's clearly a loss to society. In terms of your analysis... you would say consumers are ignoring the full social benefit of their actions, they're only considering their private benefits due to self-interest.
The end result is that the market is allocating resources at Q1, P1, where MPC cuts MPB, and that leads to an over-consumption and then an over-production of these goods and services. And as a result, there is a misallocation of resources, too many resources being allocated to this market than is socially desirable, resulting in allocative inefficiency and a welfare loss to society. So that covers...
negative x-analysis perfectly, the detailed analysis examples and diagrams, let's do the same for positive x-analyses next. Thanks for watching, guys.