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Quick run through of externalities diagrams
- 1. Quick Run Through of Externalities Diagrams AS Micro Economics Unit 1
- 2. What are externalities? • Externalities are third party ‘spill-over’ effects arising from production and consumption of goods and services for which no appropriate compensation is paid • They can cause market failure if the price mechanism does not take into account the full social costs and benefits of production and consumption • Externalities occur outside of the market i.e. they affect economic agents not directly involved in the production and/or consumption of a good or service
- 3. Private and Social Costs • Private Costs – Are paid only by the producer or consumer concerned – They are internal costs of production or consumption • Social Costs – Social Cost = Private Cost + External Cost – Negative externalities add to social costs or reduce social benefits – We assume that the consumer and/or producer does not take external costs into account when making decisions – This can lead to a misallocation of resources (causing a loss of allocative efficiency) – This means that social welfare is not maximized - a cause of market failure
- 6. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost External cost
- 7. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost Marginal private benefit = marginal social benefit
- 8. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost Marginal private benefit = marginal social benefit Q1 External cost
- 9. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost Marginal private benefit = marginal social benefit Q1Q2 A External cost A Private optimum
- 10. Quantity Costs Benefits NEGATIVE EXTERNALITIES Q1Q2 B A A Private optimum B Social optimum Marginal social cost Marginal private cost Marginal private benefit = marginal social benefit
- 11. Quantity Costs Benefits NEGATIVE EXTERNALITIES MPC MSC MPB = MSB Q1Q2 A Private optimum B Social optimum Social welfare loss
- 12. Positive Externalities • Private benefits – The utility derived from consumption (for a consumer) – The revenue accruing to a producer • Social benefit – Social benefit = Private benefit + External benefit • With positive externalities, social benefit > private benefit
- 14. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit External Benefit
- 15. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost
- 16. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost A Private optimum A
- 17. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost A Private optimum A B Social optimum B
- 18. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost A Private optimum A B Social optimum B Welfare loss from under- consumption