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An externality is something that is a by-product of a production process but affects a third party externally (the word from which 'externality' is derived).
The classic example of a negative externality is pollution.
A factory may pump loads of waste chemicals into a river as a result of their production process. This will negatively affect a third party; fishermen, for example, or a water company who will find it more difficult to filter the water. The key point is that no compensation is paid. If the factory realised what it was doing, cared (very unlikely), and paid for the water company's loss, then the problem would be solved.
Below we will look at these issues in more detail using more technical terms.
With the example of the factory, we need to divide all the costs to society into private costs and external costs. The social cost of an activity is the total cost of that activity, both privately and externally. So:
Social Cost = Private Costs + External Costs
Let us assume that our factory is making cars. The private costs to the factory owner will include things like wages, the cost of raw materials and rent. The external cost, or externality, is the cost to the third party of cleaning up the waste produced by the factory.
The total cost to society, therefore, must include the private cost, because society's resources are being used in the production process, and the external cost, because some of society's resources must be used to clear up the mess.
In the diagram above, we have a normal downward sloping demand curve and two upward sloping supply curves. The lower one, the marginal private cost, represents the car firm's supply curve (remember that the firm's supply curve is also its marginal cost curve). The other one, the marginal social cost, represents the true supply curve (and, therefore, the true marginal cost of production) for society as a whole, allowing for the external cost of production. This external cost is represented by the vertical distance between the two supply curves (AB).
The car firm does not care about the pollution. The owner is simply interested in maximising profits. The equilibrium price for him is where demand equals his supply curve, at point B, so output will be Q1 with price at P1. Given that there is pollution, though, the optimal point for the whole of society is at C, where output is Q2 and price P2. Hence, if left to the free market, cars will be over-produced at a price, which, in terms of society, is too low.
The triangle ABC represents the total deadweight loss to society as a result of the firm producing at point B. All the points within the area ABC are ones where the cost to society (represented by the MSC curve) is higher than the benefit to society (represented by the demand curve). It is a welfare loss, or a position of allocative inefficiency.
Pollution is the classic example of a negative externality, but there are others too. Noise is a good example. Congestion on the roads is also sited. This causes delays for businesses, which costs them money, and also creates pollution via exhaust fumes.
So far we have been talking about negative externalities that arise from the production process - the classic textbook example. It is possible, though, that negative externalities can arise from consumption. A moment ago I mentioned congestion as a form of negative externality arising from production. Businesses need to transport their goods around, most of this is done on the roads and so they cause congestion. But private individuals cause congestion and pollution when they drive (or 'consume') their private cars.
To illustrate this example, we need to look at private and social benefits:
Social Benefit = Private Benefit + Externality
The reason why the formula uses the term 'externality' rather than 'external benefit' (the formula above had 'external cost') is because this externality can be positive as well as negative. We will look at an example with a positive externality in a moment.
In the case of people 'consuming' their cars, the social benefit will beless than the private benefit due to the negative externality of the exhaust fumes.
Look at the diagram above. First, notice that there is only one supply curve which is labelled MSC = MPC. We are assuming, for simplicity, that there are no negative externalities from the production process, so the marginal private cost is the same as the marginal social cost.
Secondly, notice that instead of demand curves we have the marginal private benefit (MPB) and marginal social benefit (MSB) curves. This makes sense. Demand curves, as defined in the topic 'supply and demand', do effectively measure the private benefit, at the margin, of consuming a certain amount of a good. If the demand for Mars Bars in a newsagents is 100 per day at a price of 30p (as read off a demand curve) then one assumes that those 100 consumers felt that the chocolate bar would give them around 30p worth of benefit.
So, the equilibrium in the diagram is a point D, where the supply curve (MSC = MPC) equals the demand curve (MPB). But this is not the socially optimal position. The MSB curve is below the MPB curve to represent the negative eternality of private driving. The best equilibrium for society, therefore, is at point E where MSC = MSB. Hence, again, too many cars are produced and the deadweight loss triangle is DEF (the area where MSC is greater than MSB).
As stated earlier, although it is less obvious, there are examples of positive externalities. A good example is education. This includes training by firms as well as what goes on in schools and universities. If you get a good education, there are obvious private benefits; better career prospects and higher future earnings for instance. But there are external benefits as well. The obvious economic one is that a better-educated workforce is a more productive and efficient one, but there is also the fact that well educated people are less likely to resort to crime. This is almost like an avoidance of a negative externality.
The diagram above illustrates the education example. The 'price of education' axis is a bit debatable, given that the majority of school children go to state schools. Assume that there is no state education for the purpose of this example.
In the diagram, the MSC = MPC curve and the MPB curve are only showed. This is the initial equilibrium where the quantity and price of education reflects only individuals' private benefit. Spend a little time working out what should happen to this diagram given the positive externality.
Notice that there is a deadweight loss again (GHJ). This occurs because the amount of education consumed when only private interests are taken into account (Q5) is less than the socially optimal amount when one allows for the external benefit to society (Q6). It is the area where MSB > MSC. It is because education is a 'good thing' that the government do subsidise it and makes sure that all children go to school, free at the point of use, until the age of 16.
The fact that marginal social benefit is greater than marginal social cost might sound like a good thing, but it is still inefficient because it means more resources should be devoted to this area. It means that the MSC > MSB in a different market, which is a bad thing as well. A totally efficient economy would have MSB = MSC in all markets.