Chapter 17
EXTERNALITIES
1. Externalities defined
When an individual’s actions impose costs on or provide benefits for others, but the individual does not have the economic
incentive or the opportunity to take those costs or benefits into account, economists say those actions generate
externalities. Externalities are the results of actions that create harmful or beneficial side effects or by-products that are
not properly taken into account in mutually beneficial market transactions. They are, therefore, one of the principal
sources of market failure. Market failure occurs when the individual’s pursuit of one’s own interest, instead of promoting
the interests of society as a whole, can actually make society worse off. Market failure could also occur when an
individual’s actions has socially desirable consequences but because of the high private cost of that action not enough of it
is undertaken. That is, socially efficient amount is not produced.
In explaining externalities, on the benefit side of an action, we distinguish between private benefit versus social benefit of
that action. And on the cost side of an action, we distinguish between private cost versus social cost of that action.
2. Optimum Output Without Accounting for Externalities
Suppose the benefits and costs of production of a product, say, schmoo, are represented by the following benefit and cost
functions:
Total Benefit:
Total Cost:
B = 90Q − 4Q²
C = 10Q + 4Q²
Table 17-1 below shows the total benefit/cost and marginal benefit/cost of production and consumption of schmoos. Note
that the optimal quantity is 5, where the net benefit is B – C = $200, and where MB = MC. Also observe the diagram in
Figure 17-1 below.
Q
0
B = 90Q − 4Q²
$0
C = 10Q + 4Q²
$0
B−C
$0
MB = 90 − 8Q
$90
1
86
14
72
82
18
2
164
36
128
74
26
3
234
66
168
66
34
4
296
104
192
58
42
5
350
150
200
50
50
6
396
204
192
42
58
7
434
266
168
34
66
8
464
336
128
26
74
Page 1 of 8
MC = 10 + 8Q
$10
Table 17-1. Optimum
output.
Optimum output Q = 5 is
produced when
MC = MB = 50.
Q is optimal because total
net benefit is maximized
at
B – C = 350 – 150 = 200.
Figure 17-1. Unregulated market optimum output
500
B
450
The maximum net benefit: B − C = 350 − 150 = 200
is achieved at Q = 5.
400
Benefit, Cost
350
350
C
In the lower diagram, the optimal output is shown to be at
the intersection of MB and MC.
300
250
The MC curve below represents the market supply curve,
and, similarly, the MB curve is the market demand.
200
150
150
The equilibrium quantity is 5 units and the equilibrium price
is $50.
100
50
0
0
1
2
3
4
5
6
7
8
9
Quantity
Marginal Benefit and Marginal Cost
100
90
80
MC
70
60
50
40
30
MB
20
10
0
0
1
2
3
4
5
6
7
8
9
Quantity
3. Optimum Output with Externalities Accounted For
The market demand and supply of schmoos, as shown above, are drawn without taking into account the externalities. The
following shows what happens to the supply and demand when external costs and benefits are taken into account. In the
comparison of benefits and costs of allocation of resources to a certain purpose in a market system these measures include
only the benefits received by the consumers who pay for the good or service, and the compensation received by the
owners of the resources used up. However, the transaction between the buyers and sellers entails certain costs (and
benefits) that are not captured in private, mutual transactions.
For example, in the production process certain resources are used up, and if these resources are not claimed by any single
individual private entity, no compensation is made for their use. If a firm dumps the harmful by-products of a production
process in a nearby river, that river is used up as an economic resource. Disposing of the industrial by-products entails
costs, and the producer avoids these costs by dumping by-products in the river. However, since no one places a claim of
Page 2 of 8
ownership on that resource, the river, and hence no one is compensated for its use, there is no accounting for the cost of
that resource. This is an example of production externality or spillover. A resource, in this case clean water and all the
attendant uses enjoyed by others, is used up without compensation, or without taking into account the opportunity cost of
using that scarce resource. An externality therefore exists when the actions of a person or group impose an
uncompensated cost on others.
3.1. External Costs or Negative Externalities
In Figure 17-1 the benefit and cost curves in a private competitive market system represent only private benefits and costs.
If we included the social benefits or costs, then the optimum output would be different than that shown in those figures.
Figure 2 shows that if we included the external cost, that is, if we required the firms to internalize the costs (pay the
community or society as the collective owner of the resource) then the production costs would move up from the C to SC,
social cost. Also note that MC is shifted up to MSC, marginal social cost. The difference between MSC and MC is called the
marginal external cost.
Q
B = 90Q − 4Q²
SC = 26Q + 4Q²
C = 10Q + 4Q²
MB = 90 − 8Q
MSC = 26 + 8Q
MC = 10 + 8Q
0
$0
$0
$0
$90
$26
$10
1
86
30
14
82
34
18
2
164
68
36
74
42
26
3
234
114
66
66
50
34
4
296
168
104
58
58
42
5
350
230
150
50
66
50
6
396
300
204
42
74
58
7
434
378
266
34
82
66
8
464
464
336
26
90
74
Table 17-2. Including external cost in total cost and marginal cost
Including external costs in the cost function raises the total social cost above the private cost
function. Correspondingly, marginal cost shifts upward to marginal social cost (MSC). Now the
optimum output is Q = 4, where MB = MSC = $58. Note that MSC exceeds MC by $16 at each
level of output. This is the marginal external cost of producing each additional unit added to
the private marginal cost of production.
Referring to Figure 17-2, suppose we are able to measure the external cost but fail to compel the firms to internalize it.
When the firms continue to produce Q = 5, then, at that output level, marginal social cost, as measured on MSC, would
exceed MB. (Extend the vertical line from Q = 5 to intersect MSC.) Thus, when the external cost is not internalized the
market system tends to over-produce or over-allocate resources. Resources are therefore are not allocated efficiently. If
we compelled the firms to internalize the external costs then the smaller quantity Q = 4 would be produced. This would be
the socially optimum output level.
Page 3 of 8
B
Figure 17-2. Optimum output with external costs.
The maximum net benefit including external costs is now
achieved at Q = 4.
350
SC
B − SC = 296 − 168 = 128.
230
C
Total benefit, total private cost, and total social
cost
500
450
400
350
296
300
250
168
200
In the lower diagram, the socially optimal output is shown
to be at the intersection of MB and MSC.
When Q = 5, marginal social cost exceeds marginal benefit.
Resources are over-allocated. More than socially desirable
amount is being produced.
150
150
100
50
0
0
1
2
3
4
5
6
7
8
9
Quantity
Marginal benefit, marginal private cost, marginal
social cost
100
MSC
90
80
The vertical gap between MSC and MC is called the marginal
external cost (MEC).
MC
66
70
Note that when external costs are included the MC curve
shifts up. If we view the MC curve as the market supply
curve, then inclusion of social costs would lead to a decrease
in supply (shift the supply curve left).
58
60
50
50
40
30
MB
20
10
0
0
1
2
3
4
5
6
7
8
9
Quantity
3.2. Positive Externalities
An example of a positive externality is the benefits of scientific discovery or technological innovation. Even with patents or
intellectual copy rights, the impact of scientific discoveries or technological innovations is not limited to the riches for the
individual or firm taking credit for the discovery or innovation. These discoveries and innovations benefit society (and
humanity). Think of the monumental impact of Alexander Fleming’s discovery of penicillin, or Jonas Salk’s discovery of the
polio vaccine. A better example yet is education. Schooling and training “produces” educated citizens. So, educating
citizens is a production process. This production process has positive externalities or external benefits. A private
educational institution may earn profits by providing educational services. However, the private institution is not the only
one profiting in this unique production process. The rest of society also profits from producing educated persons.
Consider worker training. An individual demands education or training in the expectation of higher income. However, the
benefits of education and training spill over beyond individuals’ income earning capacity. Availability of better educated
Page 4 of 8
and well trained workers is vital for economic development and raising the standard living of the whole population. Thus
social benefit of education and training exceeds the private benefit.
In our cost benefit model now increase the total benefit function from B = 90Q – 4Q² to SB = 106Q – 4Q². Table 17-3 shows
the calculation of costs and benefits for various levels of Q. Note that MSB at each level of output exceeds MB be $16. This
represents marginal external benefit of each additional unit of output over the private marginal benefit. The socially
optimum output is now 6.
Q
B = 90Q − 4Q²
SB = 106Q − 4Q²
C = 10Q + 4Q²
MB = 90 − 8Q
0
1
MSB = 106 − 8Q
MC = 10 + 8Q
$0
$0
$0
$90
$106
$10
86
102
14
82
98
18
2
164
196
36
74
90
26
3
234
282
66
66
82
34
4
296
360
104
58
74
42
5
350
430
150
50
66
50
6
396
492
204
42
58
58
7
434
546
266
34
50
66
8
464
592
336
26
42
74
Table 17-3. Including external benefit in total benefit and marginal benefit
Including external benefit in the benefit function raises the total social benefit above the
private benefit function. Correspondingly, marginal benefit shifts upward to marginal social
benefit (MSB). Now the optimum output is Q = 6, where MB = MSC = $58. Note that MSB
exceeds MB by $16 at each level of output. This is the marginal external benefit of producing
each additional unit added to the private marginal benefit of.
Figure 17-3 shows that by including the external benefits total benefit curve would rise from B to SB. The optimum output,
that which would maximize the difference between SB and C, is now 6 units. Comparing the marginal curves, when limiting
output to Q = 5, MSB would exceed MC, implying that resources are under allocated. Output should increase to Q = 6,
where MSB = MC.
Page 5 of 8
Total benefit, total social benefit, total cost
600
Figure 17-3. Optimum output with external benefits.
The maximum net benefit including external benefits is now
achieved at Q = 6.
SB
550
492
500
430
450
400
B
B − SC = 492 − 204 = 288.
350
350
In the lower diagram, the socially optimal output is shown
to be at the intersection of MSB and MC, where
C
300
250
204
200
MSB = MC = 58
150
150
When Q = 5, marginal social benefit (66) is greater marginal
cost (50). Resources are under-allocated. Less than socially
desirable or optimum amount (Q = 6) is being produced.
100
50
0
0
1
2
3
4
5
6
7
8
9
Marginal benefit, marginal social benefit, marginal
cost
Quantity
The vertical gap between MSB and MB is called the marginal
external benefit (MEB).
110
100
90
80
MC
66
70
58
60
50
50
MSB
40
30
MB
20
10
0
0
1
2
3
4
5
6
7
8
9
Quantity
4. Internalizing Externalities: Taxes and Subsidies
Taxes and subsidies play an important role in adjusting the market behavior so as to take into account the externalities of
production and consumption. The following is a simplified model explaining how taxes and subsidies affect allocation of
resources in a market system.
4.1.
Taxes to Internalize Negative Externalities
Figure 17-2 above showed that if the external costs in production were taken into account then the industry’s marginal cost
curve would rise from MC to MSC. Note that, as explained before, the marginal cost curve represents the industry supply
curve. Imposing a tax per unit of output would raise the marginal cost (the supply curve) by exactly the per unit tax
amount.
In Figure 17-4 the graph on the left shows the original supply function as S₀ = MC = 10 + 8Q. Imposing an excise tax of $16
(equal to external cost per unit of the good) raises the marginal cost curve by exactly $16 to S₁ = MSC = 26 + 8Q. By
Page 6 of 8
90
S₁
S₀
58
50
42
26
D
Marginal benefit and marginal cost
Marginal benefit and marginal cost
imposing the pollution tax now we have achieved a socially optimum output. The diagram on the right shows the tax
imposed or collected from the consumer. The tax shifts the demand D₀ = MB = 90 – 8Q to D₁ = 74 – 8Q. Whether the tax is
collected from the producer or the consumer, the outcome is the same. The socially optimum quantity is Q = 4.
10
90
74
S₀
58
50
42
D₀
10
4
5
Quantity
D₁
4
5
Quantity
Figure 12-4. Using tax to account for negative externalities.
To reduce the production/consumption of a good with negative externalities (external costs) a per unit tax of
$16 is imposed. The tax can be imposed on the producer or the consumer. The diagram on the left shows the
tax on the producers. The one on the right shows the tax on the consumer. The outcome is the same. The
socially optimum equilibrium quantity is Q = 4. After the tax consumers pay $58 and producers receive $42,
compared to the pre-tax equilibrium price of $50.
4.2.
Subsidies to Externalize Positive Externalities
To encourage an economic activity that involves positive externalities or external benefits, the government provides a
subsidy. Now, the diagram on the left shows the subsidy paid to the producer. The subsidy in effect lowers the cost of
production to the producer. Therefore, the supply shifts to the right (down) from S₀ = MC = 10 + 8Q to S₁ = MSC = −6 + 8Q.
The new equilibrium quantity is Q = 6. The diagram on the right shows the subsidy or grant paid to the consumer. The
subsidy in effect increases the income of the consumer. As a result the demand shifts up (to the right) from
D₀ = MB = 90 − 8Q to D₁ = MSB = 106 – 8Q increasing the equilibrium output to the socially optimum quantity of Q = 6. The
effect is the same. After the subsidy the optimum quantity is 6; consumers pay $42 and producers receive $58. Supporting
public education is a perfect example of subsidy.
Page 7 of 8
90
S₀
58
S₁
50
42
D
10
Marginal benefit and marginal cost
Marginal benefit and marginal cost
106
90
S₀
58
50
42
D₁
D₀
10
5
Quantity
6
5
6
Quantity
Figure 17-5. Using subsidies to increase output of goods with positive externalities.
To increase the production/consumption of a good with positive externalities (external benefits) the
government provides a per unit subsidy of $16. The subsidy may be provided to the producer or the
consumer. The diagram on the left shows the subsidy provided to the producers. The one on the right shows
the subsidy (grant) paid to the consumer. The outcome is the same. The socially optimum equilibrium
quantity is Q = 6. With the subsidy consumers pay $42 and producers receive $58, compared to the presubsidy equilibrium price of $50.
Page 8 of 8