Negative and positive externalities
An externality is a cost or benefit that falls on people outside a transaction. Externalities are among the most important reasons markets fail.
What an externality is
An externality occurs when a transaction affects third parties who did not choose to be involved and are not compensated. A factory polluting a river imposes costs on people downstream; a neighbour's beautiful garden gives benefits to passers-by. Because these effects are not priced, the market ignores them.
Negative externalities
With a negative externality, the social cost of production exceeds the private cost paid by the producer. Examples include pollution, noise, traffic congestion, and antibiotic overuse spreading resistance. The market produces more than the socially efficient quantity, because producers and buyers do not pay the full cost.
Positive externalities
With a positive externality, the social benefit exceeds the private benefit. Examples include vaccination (protecting others), education (a more productive, informed society), and research (ideas others can build on). The market produces less than the socially efficient quantity, because buyers do not capture all the benefits.
Private versus social
Marginal social cost = marginal private cost + marginal external cost. Marginal social benefit = marginal private benefit + marginal external benefit. The efficient quantity is where marginal social benefit equals marginal social cost. Markets reach the private equilibrium, which differs when externalities exist.
Deadweight loss from externalities
When there is a negative externality, units produced beyond the social optimum cost society more than they are worth, creating deadweight loss. With a positive externality, the units not produced up to the social optimum would have been worth more than they cost, which is also lost surplus.
Production and consumption externalities
Externalities can arise from production (a factory's emissions) or consumption (second-hand smoke, loud music, driving a car in a crowded city). Network externalities, where a product becomes more valuable as more people use it, such as telephones and social networks, are a special positive case.
Worked example
A chemical plant's private marginal cost of a tonne of output is 100 dollars, but each tonne causes 30 dollars of pollution damage downstream. The marginal social cost is 130 dollars. The market produces where demand meets the 100-dollar private cost curve; the efficient quantity is lower, where demand meets the 130-dollar social cost curve.
Global externalities
Some externalities cross borders or generations. Greenhouse gas emissions anywhere contribute to climate change everywhere, and today's emissions affect future generations. The Stern Review in 2006 called climate change the greatest market failure the world has seen.
Key takeaways
Externalities are uncompensated effects on third parties. Negative externalities make social cost exceed private cost, causing overproduction; positive externalities make social benefit exceed private benefit, causing underproduction. Efficiency requires marginal social benefit to equal marginal social cost. Climate change is a global, intergenerational externality.
Flashcard
Uncompensated effect on third parties
Check your understanding
Why do free markets tend to underproduce vaccinations?