Managerial Economics

Externalities

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KING'S, MBA - 2015

Definition

In the course of producing and consuming some commodities, harmful or beneficial side effects arise that are borne by firms and people not directly involved in the production or consumption of the commodities

These side effects are called externalities

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contd.. An externality refers to the uncompensated

impact of one person’s actions on the well-being of a bystander

Externalities cause markets to be inefficient, and thus fail to maximize total surplus

An externality arises...when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

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Contd..

When the impact on the bystander is adverse, the externality is called a negative externality (Also called External Diseconomies)

When the impact on the bystander is beneficial, the externality is called a positive externality (Also called External Economies)

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Contd..

Negative Externalities in Production Air pollution by the factories through

emitting smoke Waste of industries/factories poured into

streams or ocean create health hazard to those people who live in surrounding areas

Positive Externalities in Production Construction of a bridge or a highway which

reduces transportation costs and increases the land value in neighboring area.

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Contd..

Negative Externalities in Consumption A loud music played by your neighbor may

disturb you and cause a lot of dissatisfaction Barking dog also create a negative externality

because neighbors are disturbed by the noise

Positive Externalities in Consumption If a person maintains a beautiful garden,

he/she not only increases his/her own satisfaction but also his/her neighbor enjoys the look of his/her garden.

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Contd..

In negative externality

Social cost = private cost + external cost

Here external cost = cost to those people or firms affected by externalities

Cost is denoted by supply curve

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Contd.. In positive externality

Social value = private value + external value

Here external value = value to those people or firms affected by externalities

Value is denoted by Demand curve

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The Market for Commodity

Quantity of A0

Price of A

Equilibrium

Demand(private value)

Supply(private cost)

QMARKET

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Contd..

In the presence of negative externality, the social cost of the good exceeds the pvt costs.

The optimal quantity, Qoptimum, is therefore smaller than the equilibrium quantity.

In other words, Negative externalities lead markets to produce a larger quantity than is socially desirable.

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Negative Externality and the Social Optimum

Equilibrium

Quantity of A0

Price of A

Demand(private value)

Supply(private cost)

Socialcost

QOPTIMUM

Optimum

Cost of-ve externality

QMARKET 11KING'S, MBA - 2015

Contd.. The intersection of the demand curve

and the social-cost curve determines the optimal output level. The socially optimal output level is less

than the market equilibrium quantity. How to reduce equilibrium quantity?

The government can internalize an externality by imposing a tax to producer to reduce the equilibrium quantity to the socially desirable quantity.

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Contd.. In the presence of positive externality, the social

value of the good exceeds the pvt value.

The optimal quantity, Qoptimum, is therefore larger than the equilibrium quantity

In other words, Positive externalities lead markets to produce a smaller quantity than is socially desirable.

KING'S, MBA - 2015 13

Positive Externality and the Social Optimum

Quantity of A0

Price of A

Demand(private value)

Socialvalue

Supply(private cost)

QMARKET QOPTIMUM

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Contd.. The intersection of the supply curve and

the social-value curve determines the optimal output level. The optimal output level is more than the

equilibrium quantity. The market produces a smaller quantity

than is socially desirable. The social value of the good exceeds the

private value of the good.

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Contd.. How to increase equilibrium quantity?

The government can internalize an externality by providing subsidies to the producer to increase the equilibrium quantity to the socially desirable quantity.

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Contd.. Government action is not always

needed to solve the problem of externalities

Private and Charitable Organizations can also solve the problem of externalities.

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Summary When a transaction between a buyer

and a seller directly affects a third party, the effect is called an externality

Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity

Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity

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Contd…

Those affected by externalities can sometimes solve the problem privately

When private parties cannot adequately deal with externalities, then the government steps in

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