E XTERNALITIES

The are two parties in the market Producers and Consumer Producers and Consumer Externalities are costs or benefits that affect those other than the consumer or producer (the third party) Externalities are costs or benefits that affect those other than the consumer or producer (the third party) These costs or benefits are not taken into account in the costs of production or consumption. These costs or benefits are not taken into account in the costs of production or consumption. Externalities are also known as “Spillovers” as the cost or benefit spills over from the producer or the consumer Externalities are also known as “Spillovers” as the cost or benefit spills over from the producer or the consumer

S OCIAL E QUILIBRIUM – F OR GOODS WITH E XTERNALITIES To find the allocative efficient outcome, we should attempt to take into account all the costs of production and benefits of consumption this will give us the social optimum output level.

K EY W ORDS – C OPY DEFINITIONS INTO YOUR GLOSSARY Private marginal cost (MC) = The cost of production paid by the firm e.g. wages. This is the firms supply curve Social Marginal Cost = The total cost to society from the production of a good. It is the MC + any spillover costs to society Spillover costs = A negative side effect to a third party as a result of consumption or production of a good Third Party = someone who is not directly involved in the production or consumption of a good.

Private Marginal benefit (MB) = the benefit (utility) gained from the consumption of a good. Shown as the demand curve Social Marginal benefit (SMB) = the total benefit to society from consumption. It is the MB + any spill over benefits to society Spill over benefits = A positive side effect to a third party from either consumption or production

S OCIAL E QUILIBRIUM – G OODS WITH E XTERNALITIES SMC SMB Costs/ benefits Output P Q Social equilibrium occurs where SMC =SMB

P RIVATE VS S OCIAL E QUILIBRIUM Private equilibrium where D = S (MC=MB) is allocatively efficient for private goods (goods with no externalities). But will be allocatively inefficient for good with externalities as all the costs and benefits are not being taken into account. This leads to market failure, resulting in the need for government intervention.

 Costs that are imposed on third parties as a result of productive activity  The well being of third party is reduced – this is the cost  These costs to third parties are not taken into account by producers and therefore no compensation is paid  Too much of these goods will be produced.

MSC The social costs (MSC) of production are greater than the private costs (MC) of production  The free market will under price (P P ) and over produce (Q P )the good when compared with the socially desirable price and output. (P S and Q S )  E.g.Pollution QPQP QSQS P PSPS

 Benefits that are gained by third parties as result of productive activities  The well being of the third party is increased- this is the benefit  Producers are not able to charge for the benefits but third parties can still enjoy benefits for free  As a result too little of these goods will be produced.

MSC The social costs of production are less than the private costs of production The free market will over price and under produce the good when compared with the socially desirable price and output Tree Planting

 Benefits gained by third parties as a result of consumption  Benefits that consumers create but have no way of being compensated for by those who benefit at no cost  Too less of these goods will be consumed as all the benefits of consumption are not taken into account in decision making process

SMB Social benefits of consumption are greater than the private benefits of consumption The free market will over price and under produce the good when compared with the socially desirable price and output level Using public transport

 Can u think of some examples of negative production and consumption externalities?  Can u think of some examples of positive production and consumption externalities?

 What effects our decision making process?  Producers decisions are based on their Marginal costs  Consumers benefit from consumption and their decisions are based on their Marginal benefits.  When externalities are present the true costs or benefits to society may not be reflected in individual MB and MC curves.

E XTERNALITIES The are two parties in the market Producers and Consumer Producers and Consumer Externalities are costs or benefits that affect those other than the consumer or producer (the third party) Externalities are costs or benefits that affect those other than the consumer or producer (the third party) These costs or benefits are not taken into account in the costs of production or consumption. These costs or benefits are not taken into account in the costs of production or consumption. Externalities are also known as “Spillovers” as the cost or benefit spills over from the producer or the consumer Externalities are also known as “Spillovers” as the cost or benefit spills over from the producer or the consumer

N EGATIVE E XTERNALITIES OF P RODUCTION Costs that are imposed on third parties as a result of productive activity The well being of third party is reduced – this is the cost These costs to third parties are not taken into account by producers and therefore no compensation is paid Too much of these goods will be produced.

T HE E FFECT OF E XTERNALITIES - N EGATIVE E XTERNALITIES OF PRODUCTION MSC  The social costs of production are greater than the private costs of production  The free market will under price and over produce the good when compared with the socially desirable price and output.  Pollution

P OSITIVE E XTERNALITIES OF P RODUCTION Benefits that are gained by third parties as result of productive activities The well being of the third party is increased- this is the benefit Producers are not able to charge for the benefits but third parties can still enjoy benefits for free As a result too little of these goods will be produced.

T HE E FFECT OF E XTERNALITIES - P OSITIVE E XTERNALITIES OF P RODUCTION MSC The social costs of production are less than the private costs of production The free market will over price and under produce the good when compared with the socially desirable price and output Tree Planting

N EGATIVE E XTERNALITIES OF C ONSUMPTION Costs imposed on third parties as a result of consumption These costs are avoidable by consumers but do not directly affect the consumer These costs are not taken into consideration by the consumer in the decision making process Too much of these types of goods will be consumed Can u think of some examples of negative consumption externalities?

T HE E FFECT OF E XTERNALITIES - N EGATIVE E XTERNALITIES OF C ONSUMPTION MSB The social benefits of consumption are less than the private benefits of production The free market will under price and over produce the good when compared with the socially desirable price and output level Smoking

P OSITIVE E XTERNALITIES OF C ONSUMPTION Benefits gained by third parties as a result of consumption Benefits that consumers create but have no way of being compensated for by those who benefit at no cost Too less of these goods will be consumed as all the benefits of consumption are not taken into account in decision making process

T HE E FFECT OF E XTERNALITIES - P OSITIVE E XTERNALITIES OF C ONSUMPTION SMB Social benefits of consumption are greater than the private benefits of consumption The free market will over price and under produce the good when compared with the socially desirable price and output level Using public transport

E XTERNALITIES Can u think of some examples of negative production and consumption externalities? Can u think of some examples of positive production and consumption externalities?

T HE EFFECT OF EXTERNALITIES What effects our decision making process? Producers decisions are based on their Marginal costs Consumers benefit from consumption and their decisions are based on their Marginal benefits. When externalities are present the true costs or benefits to society may not be reflected in individual MB and MC curves.