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

4. Quantity
Costs
Benefits
NEGATIVE EXTERNALITIES
Marginal
private cost

5. Quantity
Costs
Benefits
NEGATIVE EXTERNALITIES
Marginal
private cost
Marginal
social cost

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

13. Quantity
Costs
Benefits
POSITIVE EXTERNALITIES
Marginal Private
Benefit
Marginal Social
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