Externalities: private, external and social costs and benefits

Overview

Externality and explain what makes it external, production externality and a consumption externality and claim that all negative externalities should be eliminated entirely.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define an externality and explain what makes it external.

   Model answer

   An externality is a cost or benefit arising from production or consumption that falls on a third party who is neither the buyer nor the seller, and which is not reflected in the market price. What makes it external is precisely that it escapes the transaction: no payment is made for the damage caused or the benefit conferred, so neither party has any incentive to take it into account. Externalities can arise on the production side or the consumption side, and can be negative or positive.

2. 2

   Write down the relationship between private, external and social costs, and do the same for benefits.

   Model answer

   Social cost equals private cost plus external cost, and social benefit equals private benefit plus external benefit. The relationships hold at the margin as well as in total, so marginal social cost equals marginal private cost plus marginal external cost, and marginal social benefit equals marginal private benefit plus marginal external benefit. Where the external element is zero the social and private magnitudes coincide. A negative externality makes the external term positive on the cost side; a positive externality makes it positive on the benefit side.

3. 3

   A haulage firm's lorries wear down local roads and raise noise levels near homes. Identify the private and the external costs.

   Model answer

   The private costs are those the firm itself pays: fuel, drivers' wages, vehicle maintenance, insurance and depreciation. The external costs fall on people outside the transaction: residents suffer noise and worse air quality, other road users face congestion and vehicle damage, and the local authority pays for road repair out of funds raised from taxpayers rather than from the haulier. Social cost is the sum of the two, and it is the figure the firm's output decision leaves out.

4. 4

   Who bears the cost when a chemical plant discharges waste into a river? Set out the consequences for each economic agent.

   Model answer

   Consumers of the plant's output gain, because the price they pay omits the damage. The firm gains, since its private costs sit below the true social costs and its profits are correspondingly higher. Third parties bear the loss: anglers and water users lose amenity, downstream farms may lose yields, and residents may face health effects. Government bears monitoring and clean-up costs funded by taxpayers. Those who benefit and those who are harmed are therefore different groups.

5. 5

   Analyse the consequences for workers of a negative production externality generated by their own industry.

   Model answer

   Workers gain in the short run, because output and employment in the industry are higher than the socially optimal level, so jobs and wages are being supported by costs the firm does not pay. Against that, workers may themselves be exposed to the pollution, and if the externality is later corrected and output falls towards the optimum, the adjustment falls on them as job losses. Workers in affected third-party industries, such as fishing downstream of a polluting plant, lose output and income immediately.

6. 6

   Vaccination protects the person vaccinated and reduces the chance that others catch the disease. Which type of externality is this, and who are the third parties?

   Model answer

   This is a positive consumption externality. The private benefit is the protection the vaccinated person receives; the external benefit is the reduced risk of infection for everyone else, including those who cannot be vaccinated. The third parties are unvaccinated members of the community, employers who lose fewer working days, and the health service, which treats fewer cases. Because individuals weigh only their private benefit, consumption settles below the socially optimum level.

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