Externalities
In one line. An externality is a cost or benefit of production or consumption that falls on a third party and is not in the market price. Negative externalities cause overproduction (Qm above Qs); positive externalities cause underconsumption (Qm below Qs).
Exam relevance: the highest-yield micro theme, market failure and its correction appear almost every year, on ETG analysis. Taught the way an economics tutor who wrote the answer keys teaches it.
01What an externality is
An externality is a cost or benefit that spills onto people who are not party to the transaction, so the market price does not capture the full effect on society.
An externality is a cost or benefit of production or consumption that falls on a third party not involved in the activity, and that is not reflected in the market price.
Because the producer or consumer ignores the third party effect, the free market output Qm differs from the social optimum Qs, and welfare is not maximised.
02Negative externalities
A negative externality imposes a cost on third parties, so the marginal social cost lies above the marginal private cost and the good is overproduced.
Carbon emissions and traffic congestion are standard cases: the firm or driver bears the private cost but not the pollution or delay imposed on others, so too much of the activity takes place.
03Positive externalities
A positive externality confers a benefit on third parties, so the marginal social benefit lies above the marginal private benefit and the good is underconsumed.
Vaccination and education are standard cases: the individual gains privately, but others also benefit through herd immunity or a more productive workforce, so the free market provides too little.
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04Production and consumption sides
Before drawing anything, decide whether the externality is on the production side or the consumption side, because it changes which curve diverges.
- Production externality: the divergence is on the cost side (MSC away from MPC).
- Consumption externality: the divergence is on the benefit side (MSB away from MPB).
05Common misconceptions
Name the specific third party cost or benefit, not just "it is bad" or "it is good". And always show Qm against Qs with the welfare loss triangle; an externality diagram with no divergence and no welfare loss earns little.
06Test yourself
- Using a diagram, explain why a factory that pollutes a river overproduces relative to the social optimum.
- Why does a positive consumption externality lead to underconsumption rather than overconsumption?
07Questions students ask
An externality is a cost or benefit from production or consumption that falls on an uninvolved third party and is not reflected in the market price. Because the decision maker ignores it, the market over or under produces relative to the social optimum, which is a market failure.
A negative externality imposes a cost on third parties, so marginal social cost exceeds marginal private cost and the good is overproduced (Qm above Qs). A positive externality confers a benefit on third parties, so marginal social benefit exceeds marginal private benefit and the good is underconsumed (Qm below Qs).
By internalising the external cost so the decision maker faces it. A Pigouvian tax set equal to the marginal external cost raises private cost to social cost and moves output to Qs; tradeable permits and regulation are alternatives. The right size is hard to set, which is where the evaluation lies.