Externalities & Market Failure
What is an externality?
• This arises when a person or firm engages in an
activity that influences the well-being of others
and yet neither pays nor receives compensation
for that effect
• Factoring in externalities shows the true costs
and benefits to society
Negative Externality
Positive Externality
The activity causes a negative impact on
the well-being of society
The activity causes a positive impact on
the well-being of society
Negative or Positive?
Externality Terms
• Marginal private benefit
– The benefit derived by the private consumer
Carla’s MPB when planting one flower
is her enjoyment of gardening.
Externality Terms
• Marginal private benefit
– The benefit derived by the private consumer
• Marginal private cost
– The private cost to the producers of a good
associated with the good’s production
The MPC of Carla planting one flower
could be $10 (for the seed, soil, etc.)
Externality Terms
• Marginal private benefit
– The benefit derived by the private consumer
• Marginal private cost
– The private cost to the producers of a good
associated with the good’s production
• Marginal social benefit
– The private benefit plus any external benefits
placed on society
The MSB of Carla planting one flower is her
enjoyment of gardening AND the beautiful scent
it emits that the neighbors love
Externality Terms
• Marginal private benefit
– The benefit derived by the private consumer
• Marginal private cost
– The private cost to the producers of a good
associated with the good’s production
• Marginal social benefit
– The private benefit plus any external benefits
placed on society
• Marginal social cost
– The private cost plus any external costs placed on
society
The MSC of Carla planting one plant is $10 AND
the extra space that was taken away for the
neighborhood kids to play
Graphing the impact of externalities
A market graph
A market graph when describing
externalities
Lets look at the car market. Lets
assume that there are NO
government regulations on car
production…
The externalities of car production
would create MARKET FAILURE!
Sometimes the production of the
good produces a cost that is NOT
included in the marginal private
cost of production
For example, when a firm pollutes
the air during production, this cost
of pollution to society is NOT
included in the MPC of production
The pollution cost is a negative
externality
When the pollution cost is added
to the MPC of production, you
then get the marginal social cost
to society
So, the marginal social cost is the
TRUE cost of producing a car.
Let’s look at this graphically…
Externalities and their affects
• Causes market failure
– Creates deadweight loss (Total surplus not
maximized)
– Causes either an over-allocation or underallocation of resources.
• Producing at the socially efficient
equilibrium will offset the impact of
externalities. (Where demand=supply)
Public Policy Towards Externalities
• Governments can attempt to make
markets impact by externalities more
efficient by doing many things:
– Corrective taxes
– Production regulations
– Grants and subsidies
– Etc…
Higher Education Practice
• Higher education causes society to
be more productive
–Graph the market failure
–Is it over or under allocation of
resources?
–Describe what the government can do
to correct the market failure.