5.1 Externalities: Principles of Microeconomics

Learning Objectives

• Explain and give examples of positive and negative externalities.
• Identify equilibrium price and quantity.

Introduction to Externalities

• Previously discussed perfectly competitive markets assumed no third-party impacts.
• Externalities: Impacts on external agents from market interactions.
  • Externalities can be positive or negative.
  • Optimal equilibrium for consumers and producers may be sub-optimal for society.
  • Policies can sometimes improve societal outcomes.

Understanding Externalities

• Private markets consider only consumers, producers, and the government.
  • External impacts are irrelevant to private markets.
• Externality: Third-party impacts from market transactions.
  • Negative externality: Imposes a cost on external agents.
  • Positive externality: Provides a benefit to non-market participants.

Modelling Externalities

• Adaptation of market terminology for external costs and benefits:
  • Marginal Private Benefit (MPB) = Demand curve.
  • Marginal Private Cost (MPC) = Supply curve.
  • Marginal Social Benefit (MSB) includes external benefits.
  • Marginal Social Cost (MSC) includes external costs.
• Goal: Maximize social surplus (total social benefits minus total social costs).

Negative Externalities

• Example: Pollution as a negative externality.
  • MSC curve lies above MPC curve due to external costs.
  • Market equilibrium maximizes market surplus but may not maximize social surplus.
  • Diagram analysis shows that reducing quantity below market equilibrium can increase social surplus.

Determining Surplus Maximization

• Market Equilibrium: Quantity where MPB = MPC; maximizes market surplus.
• Social Surplus Maximizing Equilibrium: Quantity where MSB = MSC; maximizes social surplus.

Pareto Improvements

• Pareto Efficiency: No one can be made better off without making someone worse off.
• Pareto Improvement: Benefits someone without making anyone worse off.
• Potential Pareto Improvement: Gains exceed losses; compensation possible but not necessary.

Positive Externalities

• Market interaction benefits non-market participants.
  • Market tends to under-produce output in presence of positive externalities.
  • Increasing quantity can lead to a Potential Pareto Improvement.

Examples

• Negative Externality: Banana farming with pesticide runoff affecting nearby stream.
• Positive Externality: Beekeeping benefiting nearby orchard.

Key Concepts

• Externalities affect third parties not involved in the transaction.
• Can be negative or positive, leading to market failures if not addressed.
• Policy interventions can correct these inefficiencies.

Glossary

• External Benefits: Benefits to third parties outside production.
• External Cost: Costs to third parties outside production.
• Externality: Market exchange affecting a third party.
• Market Failure: Inefficient resource allocation due to externalities.
• Negative Externality: Costs imposed on third parties.
• Positive Externality: Benefits received by third parties.
• Private Market: Includes only consumers, producers, government.
• Social Costs: Include private and external costs.
• Spillover: Synonymous with externality.

Exercises

• Understanding and identifying aspects of negative and positive externalities through multiple choice questions.