Lecture notes 4.3.2 Externalities

4.3.2 Externalities

 The cost or benefit to a 3rd party due to an economic transaction
 Can be positive or negative
 Negative externalities are caused by demerit goods
o Alcohol & cigarettes are negative externalities
 Positive externalities are caused by merit goods
o Education & healthcare

Private Costs

 Certain costs of production
 Rent, insurance, cost of machinery, raw materials
 Determines how much the consumer will supply
 Could refer to the market price
 Marginal private costs are the cost to the firm of producing one extra unit

Social Costs

 Social costs = private costs + external costs
 MSC = MEC + MPC

Private Benefit

 Firms revenue from selling a good

Social Benefits

 Social Benefits = Private benefit + External benefits
 External benefits are the difference between private and social benefits

External costs of production

 Occur when a good is being produced and consumes
o Pollution
 Ignoring these negative externalities leads to over provision and under pricing
 At free market equilibrium with negative externalities there is an excess pf social cost over social
benefit
 The market fails to account for negative externalizes
 If the external cost is quantifiable, it could also be called economic costs
 It is hard to find the economic costs of most negative externalities such as noise pollution

External benefits of production

 A befit from the production or consumption of goods or services
o Healthier lives through vaccinations
 MSB>MPB

Environmental externalities

 Consumption of non-renewable energy causes negative externalities