Externalities content slideshow. Designed for the Economic A level qualification. Can be used in revision and in class. Subtopics Intro to Externalities Marginal Analysis Consumption Externalities Production Externalities

1. Externalities
Lower 6th Micro
Market Failure

2. Intro to
Externalities
Externalities
Mr O’Grady

3. Intro to Externalities
Externalities: Where the trading of a good generates spill-over costs or benefits
that affect third parties in ways not reflected in the price mechanism
This can result in under or over consumption/production of the good
The spill-over can occur either when the good is made, or when the good is consumed
Externalities can be positive or negative:
Positive Externalities: Welfare gains for third parties that are not included in the price of the
economic activity
The quantity of the good traded in a free market is below the socially optimal
Negative Externalities: Welfare losses to a third party that are not included in the price of
the economic activity
The quantity of the good traded in a free market is above the socially optimal
Externalities can occur in production or consumption:
Production Externalities: spill-overs occur when the good is made
Accounted for in terms of external costs
Consumption Externalities: spill-overs occur when the good is consumed
Accounted for in terms of external benefits

4. Marginal
Analysis
Externalities
Mr O’Grady

5. Price
Quantity
D = MPB
Marginal Analysis
Marginal: Marginal refers to incremental change to one variable from an additional unit
to another.
Marginal Private Benefit (MPB): the additional utility gained directly by the individual
consuming an additional unit of a good
MPB falls with output due to diminishing marginal utility. Each successive unit of consumption brings
less and less satisfaction than the unit prior
In a free market, consumers’ MPB is shown by the market demand curve
How much consumers are willing to pay for each unit is determined by the utility gained by
consuming it.
Marginal External Benefit (MEB): the additional utility
gained by third parties from an individual consuming an
additional unit of a good for their own benefit
Marginal Social Benefit (MSB): the additional utility
gained by everyone in society from an individual
consuming an additional unit of a good
MSB = MPB + MEB
It can be considered as what the demand curve should be in
order to maximise society’s total welfare
D1 = MSB
MEB

6. Price
Quantity
S = MPC
Marginal Private Costs (MPC): the additional burden incurred by the
manufacturing firms in order to produce another unit of the good
MPC rises with output as higher wages are needed to attract more workers, greater profits
are demanded by enterprise etc.
MPC is mostly in financial terms
In a free market, producers’ MPC is shown by the market supply curve
How much suppliers are willing to sell each unit for is determined by cost if making it
Marginal External Costs (MEC): the additional costs
incurred by third parties from firms producing an
additional unit of a good
MEC can be considered as the non-financial burden on
members of the general public occurring from production
Marginal Social Cost (MSC): the additional cost
incurred by everyone in society from producing
another unit of a good
MSC = MPC + MEC
It can be considered as what the supply curve should be
in order to maximise society’s total welfare
S1 = MSC
MEC

7. Consumption
Externalities
Externalities
Mr O’Grady

8. Consumption Externalities
Consumption externalities: Where private benefits of consumption differ from the social
benefits
There are spill-overs from consumption that are not included in the price mechanism
Hence the free market outcome is suboptimal
Positive consumption externalities: The social
benefits of consumption are greater than the
private benefits
Spill-over gains occurring when the good is consumed
MSB>MPB, MEB is positive
E.g. Vaccinations
Diagram: The free-market equilibrium can be seen
where MPB=MPC (S=D) and the socially optimal
equilibrium can be seen where MSB=MSC
Underconsumption: output that occurs in a free market
(QFM) is below the socially optimal quantity (QSO)
Undervalued: the free market price (PFM) is below the
socially optimal price (PSO)
Welfare: could be increased (green triangle) by
increasing Q
The units between QFM and QSO have additional benefits
(MSB) greater than their additional costs (MSC) to society
Price
Quantity
D = MPB
QSO
S = MPC
= MSC
D1 = MSB
PFM
PSO
QFM
+ve
MEB

9. Negative consumption externalities: The social
benefits of consumption are less than the private
benefits
Spill-over losses occurring when the good is consumed
MSB<MPB, MEB is Negative
E.g. Smoking
N.B. we account these spill-over losses as reduced
external benefits rather than increase external costs as
they occur when the good is consumed
Diagram: The free-market equilibrium can be
seen where MPB=MPC (S=D) and the socially
optimal equilibrium can be seen where
MSB=MSC
Overconsumption: output that occurs in a free market
(QFM) is above the socially optimal quantity (QSO)
Overvalued: the free market price (PFM) is above the
socially optimal price (PSO)
Welfare: could be increased (red triangle) by
decreasing Q
The units between QSO and QFM have additional costs
(MSC) greater than their additional benefits (MSB) to
society
Price
Quantity
D = MPB
QSO
S = MPC
= MSC
D1 = MSB
PFM
PSO
QFM
-ve
MEB
Top tip: when showing potential welfare gains, the triangle always ‘points towards the
socially optimal quantity for any type of externality

10. Production
Externalities
Externalities
Mr O’Grady

11. Production Externalities
Production externalities: Where private costs of production differ from the social costs
There are spill-overs from production that are not included in the price mechanism
Hence the free-market outcome is suboptimal
Negative production externalities: The social costs
of production are greater than the private costs
MSC>MPC, MEC is positive
Spill-over losses occurring when the good is produced
E.g. Pollution from factories
Diagram: The free-market equilibrium can be seen
where MPB=MPC (S=D) and the socially optimal
equilibrium can be seen where MSB=MSC
Overconsumption: output that occurs in a free market
(QFM) is above the socially optimal quantity (QSO)
Under-priced: the free market price (PFM) is below the
socially optimal price (PSO)
Welfare: could be increased (red triangle) by reducing Q
The units between QFM and QSO have additional costs
(MSC) greater than their additional benefits (MSB) to society
Price
Quantity
D = MPB
= MSB
QSO
S = MPC
PFM
PSO
QFM
S1 = MSC
+ve
MEC

12. Positive production externalities: The social costs
of production are less than the private costs
MSC<MPC, MEC is negative
Spill-over gains occurring when the good is produced
E.g. Pollination from honey farmers’ bees
N.B. we account these spill-over gains as reduced external
costs rather than improved external benefits as they occur
when the good is produced
Diagram: The free-market equilibrium can be seen
where MPB=MPC (S=D) and the socially optimal
equilibrium can be seen where MSB=MSC
Underconsumption: output that occurs in a free market
(QFM) is below the socially optimal quantity (QSO)
Over-priced: the free market price (PFM) is above the
socially optimal price (PSO)
Welfare: could be increased (green triangle) by
increasing Q
The units between QFM and QSO have additional costs
(MSC) less than their additional benefits (MSB) to society
Price
Quantity
D = MPB
= MSB
QSO
S1 = MSC
PFM
PSO
QFM
S = MPC
-ve
MEC

13. Where next?
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