Post on 28-Oct-2014
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Quick Run Through of Externalities Diagrams
AS Micro EconomicsUnit 1
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
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
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
Marginal private cost
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
Marginal private cost
Marginal social cost
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
Marginal private cost
Marginal social cost
External cost
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
Marginal private cost
Marginal social cost
Marginal private benefit = marginal social benefit
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
Marginal private cost
Marginal social cost
Marginal private benefit = marginal social benefit
Q1
External cost
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
Marginal private cost
Marginal social cost
Marginal private benefit = marginal social benefit
Q1Q2
A
External cost
A
Private optimum
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
Q1Q2
B
A
A
Private optimum
B
Social optimum
Marginal social cost
Marginal private cost
Marginal private benefit = marginal social benefit
Quantity
CostsBenefits
NEGATIVE EXTERNALITIES
MPC
MSC
MPB = MSB
Q1Q2
A
Private optimum
B
Social optimum
Social welfare loss
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
Quantity
CostsBenefits
POSITIVE EXTERNALITIES
Marginal Private Benefit
Marginal Social Benefit
Quantity
CostsBenefits
POSITIVE EXTERNALITIES
Marginal Private Benefit
Marginal Social Benefit
External Benefit
Quantity
CostsBenefits
POSITIVE EXTERNALITIES
Marginal Private Benefit
Marginal Social Benefit
Marginal Private Cost
Quantity
CostsBenefits
POSITIVE EXTERNALITIES
Marginal Private Benefit
Marginal Social Benefit
Marginal Private Cost
A
Private optimum
A
Quantity
CostsBenefits
POSITIVE EXTERNALITIES
Marginal Private Benefit
Marginal Social Benefit
Marginal Private Cost
A
Private optimum
A
B
Social optimum
B
Quantity
CostsBenefits
POSITIVE EXTERNALITIES
Marginal Private Benefit
Marginal Social Benefit
Marginal Private Cost
A
Private optimum
A
B
Social optimum
B
Welfare loss from under-consumption