1. Lecture 19: Externalities & Health
Richard Smith
Reader in Health Economics
School of Medicine, Health Policy & Practice 1

2. Overview of lecture What are ‘externalities’?
Positive externalities and health
Negative externalities and health
‘Global’ externalities and health
Externalities and public goods 2

3. What are ‘externalities’?
Costs and/or benefits of actions by one party which affect other parties
Externalities exist wherever a transaction affects an uncompensated party
Policy issue – design of appropriate institutions & legislation to align individual incentives & social welfare
Externalities (with public goods) are main reason for public health care systems worldwide 2

4. Positive externality
Positive externality – where social benefit of consumption of good exceeds private benefit
Private benefit – benefit to consumers who buy and consume good
Social benefit – benefit to all in society, including those who do not consume it
 Equals private benefit of consumption plus benefit to others
Causes market failure (too little consumption) 3

5. Positive externalities & health
Caring for health of others (Good Samaritan)
interdependent utility functions
UA=U(hA, yA, hB); UB=U(hB, yB, hA), where h=health, y=income (other goods)
Private health increases national wealth
Knowledge & technology
Communicable disease surveillance & infectious disease control (Lecture 21)
Vaccination (herd immunity effect) 3

6. Positive Externality P S = MPC = MSC D = MPB Q
In equilibrium, marginal private cost equals marginal social cost with no marginal cost to other people.
The marginal private benefit curve is the demand curve.
The marginal private cost curve is the supply curve.
D = MPB Q 77

7. Positive Externality P S = MPC = MSC A Equilibrium Price PA D = MPB QQA 78

8. Positive Externality P S = MPC = MSC A Equilibrium Price PA D = MPB QQA
Equilibrium Output 79

9. Positive Externality P S = MPC = MSC A Equilibrium Price PA D = MPB Q
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
D = MPB Q QA
Equilibrium Output 80

10. Positive Externality P S = MPC = MSC A Equilibrium Price PA MSB
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
MSB
D = MPB Q QA
Equilibrium Output 81

11. Positive Externality P S = MPC = MSC B A Equilibrium Price PA MSB
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
MSB
D = MPB Q QA QB
Equilibrium Output
Herd immunity (eg 80% coverage) 82

12. Positive Externality P S = MPC = MSC B A Equilibrium Price PA MSB
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
MSB
D = MPB Q QA QB
Equilibrium Output
Economically
Efficient Output 83

13. Positive Externality P S = MPC = MSC B A Equilibrium Price PA MSB
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
MSB
D = MPB Q QA QB
Equilibrium Output
Economically
Efficient Output 84

14. Total Gain to Other People
Positive Externality P
Total Gain to Other People
S = MPC = MSC B
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
MSB
D = MPB Q QA QB
Equilibrium Output
Economically
Efficient Output 85

15. Total Gain to Other People
Positive Externality P
Total Gain to Other People
S = MPC = MSC B
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
MSB
D = MPB Q QA QB
Equilibrium Output
Economically
Efficient Output 86

16. Positive Externality P Deadweight Social Loss S = MPC = MSC B A
Total Gain to Other People
S = MPC = MSC B
Consumer Surplus A
Equilibrium Price PA
Producer Surplus
MSB
D = MPB Q QA QB
Equilibrium Output
Economically
Efficient Output 87

17. Policy options (Pigouvian) subsidies to ‘internalize’ external benefit
changing private benefits so they equal social benefits, such as providing ‘free’ vaccines
Direct provision of good, such as vaccine
Property rights to ‘correct’ market (e.g A ‘owns’ right not to be vaccinated, or B owns right to vaccinate) – UK vs USA schools 2

18. Negative externality
Negative externality – where social cost of consumption of good exceeds private cost
Private cost – cost to consumers who buy and consume good
Social cost – cost to all in society, including those who do not consume it
 Equals private cost of consumption plus cost to others
Causes market failure (too much consumption) 3

19. Negative externalities & health
Infectious disease
Large part of reason behind public health movement in 19th Century (UK=PHLS/HPA; USA=PHS/CDC)
Lecture 21 – antibiotic resistance
Environmental degradation (vehicle emissions)
Child day care
individual vs social costs and benefits
Tobacco & passive smoking 3

20. Equilibrium with a Negative Externality
Price/
Cost
Quantity 13

21. Equilibrium with a Negative Externality
Price/ Cost
S (MPC)
The marginal private cost (MPC) of producing a good is the increase in total private cost from producing an additional unit.
The marginal private cost curve is the industry supply curve under perfect competition.
D (MPB/MSB)
Quantity 14

22. Equilibrium with a Negative Externality
Price/
Cost
S (MPC) A
Equilibrium
Price PA
D (MPB/MSB) QA
Quantity 15

23. Equilibrium with a Negative Externality
Price/ Cost
MSC
S (MPC) A
Equilibrium
Price PA
The marginal social cost (MPC) of producing a good is the increase in the total social cost from producing an additional unit
D (MPB/MSB) QA
Quantity 16

24. Equilibrium with a Negative Externality
Price/ Cost
MSC B
S (MPC) A
Equilibrium
Price PA
A negative externality creates economic inefficiency because the equilibrium quantity exceeds the economically efficient quantity.
D (MPB/MSB) QB QA
Quantity 17

25. Equilibrium with a Negative Externality
Price/ Cost
MSC B
S (MPC) A
Equilibrium
Price PA
D (MPB/MSB) QB QA
Quantity
Equilibrium Output 18

26. Equilibrium with a Negative Externality
Price/ Cost
MSC B
S (MPC) A
Equilibrium
Price PA
D (MPB/MSB) QB QA
Quantity
Economically Efficient Output
Equilibrium Output 19

27. Deadweight Social Losses From SmokingP
MSC
MPC = S
Consumers purchase too much of a product in equilibrium, resulting in economic inefficiency.
Negative externalities result in deadweight social losses. D Q 22

28. Deadweight Social Losses From SmokingP
MSC
MPC = S A
PA = £3 D Q QA 23

29. Deadweight Social Losses From SmokingP
MSC
£10
MPC = S A
PA = £3 D Q QA 25

30. Deadweight Social Losses From SmokingP
MSC
£10
MPC = S A
PA = £3 D Q QA 26

31. Deadweight Social Losses From SmokingP
MSC
£10
Deadweight Social Loss
MPC = S A
PA = £3 D Q QA 27

32. Deadweight Social Losses From SmokingP
MSC
£10
Deadweight Social Loss B
PB = £5
MPC = S A
PA = £3 D Q QB QA 28

33. Deadweight Social Losses From Smoking
NOTE – the economically efficient level of production is not zero!
 It would mean doing completely without goods yielding some benefit
Economically efficient level occurs when marginal benefit of reducing externality equals the marginal cost of reducing it
Policy issue is how to achieve this level 30

34. Policy options
(Pigouvian) taxation to ‘internalize’ external cost (e.g. cigarettes, petrol)
changing private costs so they equal social costs
Regulation of overall quantity produced (rationing e.g. cigarettes, petrol)
Property rights to ‘correct’ market (e.g. A ‘owns’ right to clean air, or B owns right to pollute air – determines flow of compensation, subsidy, tax etc) 30

35. Taxation P
Old MPC A D Q 54

36. Taxation P New MPC = MSC Old MPC A D Q
To internalize an externality, the marginal private cost must equal the marginal social cost of the product. D Q 55

37. Taxation P
New MPC = MSC
Old MPC B
PB = £5 A D QB Q 56

38. Taxation P
New MPC = MSC
Old MPC B
PB = £5 A
PS = £2 D QB Q 57

39. Taxation PB Tax = £3 PS P New MPC = MSC Old MPC B A D QB Q
The highest price that a person would be willing to pay to reduce an externality is the value of the harm the externality causes that person. PS D QB Q 58

40. Problems with taxation
Taxation may not internalize all externalities (demand subject to other influences)
Taxation can internalize externalities only if transactions costs (implementing the taxation system) are sufficiently low
Coase theorem 46

41. Coase Theorem
Equilibrium is economically efficient regardless of who holds property rights – producer or consumer – when transactions costs are low
BUT: Equilibrium not economically efficient when transactions costs are high – depends on property rights, laws etc 48

42. Regulation
Direct government intervention to determine quantity of production/consumption (rather than indirectly through price)
Though incentives/quota’s (e.g. vaccine targets, incentive payments to GPs, congestion charge)
Through legislation (e.g. smoking in public places)
Through production/distribution (e.g. communicable disease surveillance) 59

43. Problems with Regulation
Costs may differ between firms and/or consumers which may not be accounted for
Uncertainty over MSB/MPB and MSC/MPC curves (required to set optimal equilibria)
Political costs
Transaction costs 59

44. ‘Global’ externalities & health
Communicable diseases
HIV/AIDS – global (geographic & demographic)
Tuberculosis - global (geographic & demographic)
Malaria - regional (geographic)
Acute Respiratory Infection, Diarrhoea – local (geographic & demographic)
Economic effects of ill-health
HIV/AIDS in Southern Africa – regional to global 50

45. ‘Global’ externality – (re)emerging infectious diseases 1996-2003
Legionnaire’s Disease
Multidrug resistant Salmonella
Cryptosporidiosis
E.coli O157
E.coli non-O157
Typhoid
SARS
BSE
Malaria
E.coli O157
nvCJD
Lyme Borreliosis
West Nile Virus
Diphtheria
West Nile Fever
SARS
Reston virus
Echinococcosis
Lassa fever
W135
Nipah Virus
Yellow fever
Cholera 0139
Reston Virus
Venezuelan
Equine Encephalitis
Buruli ulcer
RVF/VHF
Dengue haemhorrhagic fever
O’nyong-nyong fever
Ebola
haemorrhagic
fever
Human Monkeypox
Dengue haemhorrhagic fever
Cholera
Cholera
Equine morbillivirus
Hendra virus 50

46. Cost of global health externalities50

47. Externalities & public goods
Goods with significant positive externalities are often public goods
Goods with significant negative externalities are, conversely, public ‘bads’
Public goods (bads) are under (over) consumed for additional reasons
Lecture 20! 50

48. Further references
McPake B, Kumaranayake L, Normand C (2002), Health Economics: an International Perspective. London: Routledge. Chapter 8.
Getzen T (2004). Health Economics: fundamentals and flow of funds. New York: Wiley. Chapter 15.
Smith RD, Coast J. Controlling antimicrobial resistance: a proposed transferable permit market. Health Policy, 1998; 43:
Coast J, Smith RD, Millar MR. An economic perspective on policy to reduce antimicrobial resistance. Social Science & Medicine, 1998; 46:
For future ref:
Smith, RD, Drager N. Cross-border risks and public health security. Oxford University Press.
Smith RD, Drager N, Hardimann M. The rapid assessment of the economic impact of public health emergencies of international concern. World Health Organization.
Yeung RYT, Smith RD. Can we use contingent valuation to assess the private demand for childhood immunization in developing countries? Applied Health Economics and Health Policy. 50