EXTERNALITIES
EC 325
London School of Economics
, Externalities
• Externalities are one case in which the 1st Welfare Theorem breaks
down
• Externalities are present when...
1. one party’s actions make another worse (or better) off, and
2. the first party bears no cost (or receives no benefit) for the effect
they have on the second.
, Examples of Externalities
Classic examples involve negative production externalities
Suppose the production of steel generates a by-product called sludge
• Some of the sludge makes its way into a local river
• The sludge adversely effects downstream users of the river including
fishermen and boaters
• Downstream costs are not borne by the steel company
An externality is present because there is a difference between the
private and social marginal cost of steel production.
, Examples of Externalities
• Other examples include:
1. Air pollution (air quality and global warming)
2. Spreading of contagious diseases (Covid, influenza)
3. Noise pollution (crying babies)
4. Scientific research (benefits to research of others)
5. Congestion (rush hour drivers slow each other down)
EC 325
London School of Economics
, Externalities
• Externalities are one case in which the 1st Welfare Theorem breaks
down
• Externalities are present when...
1. one party’s actions make another worse (or better) off, and
2. the first party bears no cost (or receives no benefit) for the effect
they have on the second.
, Examples of Externalities
Classic examples involve negative production externalities
Suppose the production of steel generates a by-product called sludge
• Some of the sludge makes its way into a local river
• The sludge adversely effects downstream users of the river including
fishermen and boaters
• Downstream costs are not borne by the steel company
An externality is present because there is a difference between the
private and social marginal cost of steel production.
, Examples of Externalities
• Other examples include:
1. Air pollution (air quality and global warming)
2. Spreading of contagious diseases (Covid, influenza)
3. Noise pollution (crying babies)
4. Scientific research (benefits to research of others)
5. Congestion (rush hour drivers slow each other down)
