Chapter Ten
Externalities and Public Goods
Identifying Externalities
An externality is a side effect on bystanders whose interests are not considered.
Some externalities can harm others (negative externalities), and there are ones
that benefits others (positive externalities).
Negative externalities impose costs on others. These are examples below:
If one stands up during a concert, the other will not be able to see the
stage
If someone smokes next to someone, that person only smokes
secondhanded.
This type of externality is a problem because one can make a decision without
taking into consideration someone else being affected by it. These decisions cost
the other party.
Positive externalities benefit others. These are the examples:
When one purchases a TV, the people that live with them benefit from
being able to watch shows and movies from it.
Externalities, positive or negative still lead to market failure. Positive
externalities may benefit others, but they do not benefit everyone. When
applying the cost benefit principle, you may have made a decision that was of
benefit to you and maybe others. But the choice you made was at a cost of
something. To you that decision was the next best thing, and maybe to someone
else the cost you incurred was what caused someone to not make that decision.
This means that as you weighed options and came up with a decision that
benefited others, some people may do the same and decide opposite to what
you made. That still results to market failure.
Price changes are not part of externalities.
Conflict between Private Interest and Society Interest
Externalities create tension between your personal or private interest and
society’s interest. One’s private interest is about the costs and benefits that one
personally incurs. Society’s interests include all he costs and benefits incurred by
everyone. If one’s choices do not affect others, then those are private interests.
But, when one’s choices or decisions affect others, there are then externalities
and this creates conflict between one’s social and private interests. That conflict
leads to market failure.
Negative externalities cause external costs
Sellers do not focus on full sets of marginal costs. That is why there are two
different marginal costs for sellers. Firsly, there are private marginal costs.
These costs are costs that are incurred to produce one extra unit. Sellers pay
attention to these costs because they affect them personally or affect their
business as sellers. Secondly, there are costs that the sellers do not care about.
These are the costs that are imposed on bystanders. For example, when a
company produces fuel, they emit pollution of the chemicals they use in the air.
, This is an example of external marginal costs (from producing an extra unit)
which affect others outside of the sellers.
The supply curve is the private marginal cost. But, according to the society all
these costs matter, and that means the cost of that extra unit is the marginal
social cost. This cost is the sum of the marginal private cost and the
marginal external cost. The equation goes like this, Marginal Social Cost =
Marginal Private Cost + Marginal External Cost.
Positive externalities create external benefits
Decisions for buyers are guided by marginal benefits. These benefits are when
someone buys something, and they enjoy the benefits of having that thing.
Externally, when a decision is made, it benefits others too. But benefits that
affects someone personally are known as marginal private benefit. These are
the marginal benefits that a buyer enjoys from buying something. Benefits that
affect other people (bystanders), are known as marginal external benefits.
But the society considers a benefit a benefit. It does not matter if someone
experiences them personally or from others, if the benefit affects the whole
community it is known as the marginal social benefit. The marginal social
benefit is made up of the marginal private benefit and the marginal external
benefit. The marginal private benefit is the actual demand curve.
The Externality Problem
The rational rule for the society is that an item should be produced if the
marginal social benefit is at least bigger or equal to the marginal social cost. This
means that it is in the society’s benefit if producers keep producing an item as
long as the marginal social benefit is larger than the marginal social cost. All this
occurs when the marginal social benefit equals to the marginal social cost. Under
the rational rule for society, there is a socially optimal quantity. This is the kind of
quantity that is most efficient for society considering all costs and all benefits
that affect society. This means being able to figure out how much quantity will
result in the largest economic surplus possible. So, to be able to get the socially
optimal quantity is the quantity where: Marginal social benefit = Marginal
social cost.
These are the steps that help analyse externalities:
1. Predict the equilibrium quantity
The equilibrium quantity is predicted to forecast what you think will
happen. This is when you find where demand equals to supply.
2. Assess what externalities are involved
Assess whether the externalities are positive or negative. Do they harm or
benefit the bystanders?
3. Find socially optimal quantity
This is the quantity that is in the society’s best interest. Here, marginal
social benefit is equal to marginal social cost. However, to be able to
figure out the socially optimal quantity, we use the Rational Rule for
Society.
4. Compare the forecast for the equilibrium quantity and the socially
optimal quantity
Compare what will happen (equilibrium quantity) with what is considered
as the society’s best interest (socially optimal quantity). If there is a
negative externality, the equilibrium quantity will be higher than the
Externalities and Public Goods
Identifying Externalities
An externality is a side effect on bystanders whose interests are not considered.
Some externalities can harm others (negative externalities), and there are ones
that benefits others (positive externalities).
Negative externalities impose costs on others. These are examples below:
If one stands up during a concert, the other will not be able to see the
stage
If someone smokes next to someone, that person only smokes
secondhanded.
This type of externality is a problem because one can make a decision without
taking into consideration someone else being affected by it. These decisions cost
the other party.
Positive externalities benefit others. These are the examples:
When one purchases a TV, the people that live with them benefit from
being able to watch shows and movies from it.
Externalities, positive or negative still lead to market failure. Positive
externalities may benefit others, but they do not benefit everyone. When
applying the cost benefit principle, you may have made a decision that was of
benefit to you and maybe others. But the choice you made was at a cost of
something. To you that decision was the next best thing, and maybe to someone
else the cost you incurred was what caused someone to not make that decision.
This means that as you weighed options and came up with a decision that
benefited others, some people may do the same and decide opposite to what
you made. That still results to market failure.
Price changes are not part of externalities.
Conflict between Private Interest and Society Interest
Externalities create tension between your personal or private interest and
society’s interest. One’s private interest is about the costs and benefits that one
personally incurs. Society’s interests include all he costs and benefits incurred by
everyone. If one’s choices do not affect others, then those are private interests.
But, when one’s choices or decisions affect others, there are then externalities
and this creates conflict between one’s social and private interests. That conflict
leads to market failure.
Negative externalities cause external costs
Sellers do not focus on full sets of marginal costs. That is why there are two
different marginal costs for sellers. Firsly, there are private marginal costs.
These costs are costs that are incurred to produce one extra unit. Sellers pay
attention to these costs because they affect them personally or affect their
business as sellers. Secondly, there are costs that the sellers do not care about.
These are the costs that are imposed on bystanders. For example, when a
company produces fuel, they emit pollution of the chemicals they use in the air.
, This is an example of external marginal costs (from producing an extra unit)
which affect others outside of the sellers.
The supply curve is the private marginal cost. But, according to the society all
these costs matter, and that means the cost of that extra unit is the marginal
social cost. This cost is the sum of the marginal private cost and the
marginal external cost. The equation goes like this, Marginal Social Cost =
Marginal Private Cost + Marginal External Cost.
Positive externalities create external benefits
Decisions for buyers are guided by marginal benefits. These benefits are when
someone buys something, and they enjoy the benefits of having that thing.
Externally, when a decision is made, it benefits others too. But benefits that
affects someone personally are known as marginal private benefit. These are
the marginal benefits that a buyer enjoys from buying something. Benefits that
affect other people (bystanders), are known as marginal external benefits.
But the society considers a benefit a benefit. It does not matter if someone
experiences them personally or from others, if the benefit affects the whole
community it is known as the marginal social benefit. The marginal social
benefit is made up of the marginal private benefit and the marginal external
benefit. The marginal private benefit is the actual demand curve.
The Externality Problem
The rational rule for the society is that an item should be produced if the
marginal social benefit is at least bigger or equal to the marginal social cost. This
means that it is in the society’s benefit if producers keep producing an item as
long as the marginal social benefit is larger than the marginal social cost. All this
occurs when the marginal social benefit equals to the marginal social cost. Under
the rational rule for society, there is a socially optimal quantity. This is the kind of
quantity that is most efficient for society considering all costs and all benefits
that affect society. This means being able to figure out how much quantity will
result in the largest economic surplus possible. So, to be able to get the socially
optimal quantity is the quantity where: Marginal social benefit = Marginal
social cost.
These are the steps that help analyse externalities:
1. Predict the equilibrium quantity
The equilibrium quantity is predicted to forecast what you think will
happen. This is when you find where demand equals to supply.
2. Assess what externalities are involved
Assess whether the externalities are positive or negative. Do they harm or
benefit the bystanders?
3. Find socially optimal quantity
This is the quantity that is in the society’s best interest. Here, marginal
social benefit is equal to marginal social cost. However, to be able to
figure out the socially optimal quantity, we use the Rational Rule for
Society.
4. Compare the forecast for the equilibrium quantity and the socially
optimal quantity
Compare what will happen (equilibrium quantity) with what is considered
as the society’s best interest (socially optimal quantity). If there is a
negative externality, the equilibrium quantity will be higher than the
