A spillover cost or benefit that accrues from the consumption or production of a good. An externality is an effect on others who did not have a choice and whose interests were not taken into account when a good was produced or consumed. WARNING: printing this ppt will not provide a readable set of notes

The vertical axis is now measuring MB and MC Supply, on the other hand, is derived from the marginal cost of production and is the price. This means thinking about demand as the marginal benefit gained by consumers of a product. It will be expressed by their willingness to pay for a product. To examine externalities we need to do a COST-BENEFIT analysis of the market. Supply Price Quantity Demand Marginal Benefit Marginal Cost MB/MC MB and MC only include the private benefits and costs that come from consuming or producing a product. Any externality adds a social cost or social benefit to these curves. Equilibrium price and quantity are the private equilibrium only.

A benefit to the community over and above the private benefits that accrue to the consumers and producers directly involved in the transaction. Negative Externalities… …from Consumption…from Production Examples would include air, water, noise, visual or other pollution that is created as a good is produced. Examples would include the recreational possibilities of a hydro- dam or commercial forest. Examples would include the benefits to be had from public transport use or vaccination programmes. Examples would include pollution that comes from consuming a good (passive smoking) or harmful behaviours (drunken brawls). …from Consumption…from Production Positive Externalities… A cost that is borne by the community over and above the private costs that accrue to the consumers and producers directly involved in the transaction. more details

MC MB/MC Quantity MB Paper Market Effectively, society is subsidising this producer by not holding them accountable for their pollution. If these costs were added to the cost curve, then the Marginal Social Cost curve would be higher. Society would rather pay more for paper and have less produced because of this negative externality. The social costs of releasing polluted water may include the loss of: Negative Externalities from Production back Take for example the market for paper from a mill beside a river. Large amounts of water to wash the pulp are taken from the river. In a free market the cheapest (profit maximising option) would be to release this water, loaded with chemicals, back into the river. The private (free market) equilibrium position is shown as P e, Q e PePe QeQe fish and plant life a recreational area drinking water MSC And a subsidy creates a deadweight loss. PsPs QsQs social subsidy

The private (free market) equilibrium position is shown as P e, Q e When we add in the social costs, they are almost non- existent at low levels of consumption, but accelerate as smoking rates increase. The Marginal Social Cost curve would look like this. Negative Externalities from Consumption MC MB/MC Quantity MB When considering externalities of consumption, the marginal cost is a constant as individual consumers cannot influence the market price of a product. Take the social cost of second-hand smoke that results from cigarette smoking. Non-smokers are at risk of developing cancers or suffering in other ways. PePe QeQe In a free market, society would be subsidising smokers by not holding them accountable for the harm they do others. So society would rather pay more and see less tobacco consumed. MSC PsPs QsQs social subsidy And, of course, there is a deadweight loss. Cigarettes back

from Production Positive Externalities MC MB/MC Quantity MB Hydro-Electicity The production process can sometimes produce positive spillovers for society. Hydro dams create large lakes that provide a range of recreational and sporting opportunities for the wider community (eg Lake Karapiro). The free market equilibrium (P e Q e ) does not include these positive externalities. PePe QeQe To provide equivalent facilities would cost a great deal, so the hydro firm could be said to be reducing costs for society. The Marginal Social Cost curve would be lower that the private MC curve. MSC Society would like a greater number of hydro lakes, and there is a deadweight loss if they are not provided. QsQs back

Society’s preference is for greater levels of vaccination than would happen in a free market. Positive Externalities from Consumption Vaccination programmes provide benefits beyond those who receive the jabs. The virtual elimination of polio, small pox and other diseases has allowed people to live longer, healthier and more productive lives. MC MB/MC Quantity MB Polio Vaccination Yet developing vaccines has a high cost and the public doesn’t necessarily appreciate their benefit. The free market equilibrium position is P e, Q e When the positive externalities are included, the MSB curve will be to the right of the MB curve. PePe QeQe MSB And, of course, there is the deadweight loss if that preference is not met. QeQe back

what can be done about them the The goal is to remove the deadweight loss by getting private costs and benefits to shift to the same equilibrium point as the social costs and benefits. In particular, society is concerned about reaching the socially desirable quantity of the good in question.

This means moving the MC curve to equal the MSC curve. Negative Externalities from Production MC MB MSC PePe MB/MC Quantity Paper Market QeQe QsQs How can we get the polluter to incorporate these external costs into their (internal) production costs? The policy options for the government include: Taxing polluters Regulating emissions With either policy the aim is to remove the deadweight loss that occurs in the free market by shifting to the socially optimum level of output (Q s ). A tax, if it is set correctly, will shift the MC upward. A tax, however, doesn’t prevent pollution. Regulating emissions would reduce pollution, and firms would be required to meet the cost of anti-pollution measures. The effect on the graph, though, would look the same. MC

Negative Externalities from Consumption MC MB MSC MB/MC Quantity Cigarettes PePe QeQe QsQs Society wants less people to smoke. But if people will still smoke, how can we get smokers to pay for the harm their smoking does to others? The goal is to reduce consumption to Q s. Taxing smokers Regulating sales Education A tax will raise the MC curve, reducing consumption towards the desired level. Regulations can be imposed restricting access, or making it harder to smoke. Such measures would reduce demand (the MB curve), achieving the same result as a tax. MC An education initiative (ad campaigns, warning on packs, etc) would also reduce demand. Policy options include:

Positive Externalities from Production MC MB/MC Quantity MB Hydro-Electicity MSC PePe QeQe QsQs If hydro lakes are such good community resources, how do you get the power companies to build one near you?

Positive Externalities from Consumption QeQe MC MB/MC Quantity MB Polio Vaccination MSB PePe QeQe All in society gain if more people are vaccinated. But some object to vaccination, some are not aware of the benefits, some cannot afford it, or simply wont bother. How do we raise ‘consumption levels’?