• Externalities?occur when there is an external impact?on a third party?not involved in the economic transaction
  • These impacts can be?positive or negative?and are often referred to as?spillover effects
  • These impacts can be on the?production side?of the market (producer supply) or on the?consumption side?of the market (consumer demand)
• External costs?occur when the?social costs?of an economic transaction are greater than the?private costs
  • A?private cost?for the producer is?what they actually pay?to produce a good/service
  • An?external cost (negative externality)?is the damage not factored in to the economic activity (for example, generating air pollution when producing electricity)
  • Private cost + external cost = social costs
• External benefits?occur when the?social benefits?of an economic transaction are greater than the?private benefits
  • A?private benefit?for the consumer is?what they actually gain?from consuming a good/service
  • An?external benefit (positive externality)?is the benefit not factored in to the economic activity (for example, someone who studies law enjoys private benefits but society benefits from having strong legal institutions)
  • Private benefit + external benefit = social benefits

• Negative externalities of production are often created during the production of a good/service
• The market is failing due to?over-provision?of these goods/services as only the?private costs are considered?by the producers and not the?external costs
  • If the?external costs?were considered, the quantity of the goods/services provided?would decrease?and they would be sold at a higher price
• Marginal analysis?in economics considers the?cost or benefit of the next unit produced or consumed
  • The?marginal private cost (MPC)?is the cost of?the next unit?produced or consumed
  • The?marginal private benefit (MPB)?is the benefit derived from the production or consumption of?the next unit

External costs of production (negative externality) result in an over-provision shown by the gap between Qopt?and Qe

Diagram Analysis

• The?marginal social benefit (MSB)?is assumed to be equal to the?marginal private benefit (MPB)?as the focus is on the?producer side?of the market
• The free-market equilibrium can be seen at PeQe. This is where the?MPC = MSB
• The larger the?external costs?in production, the larger the gap between the?MPC?and the?marginal social cost (MSC)
• The optimal allocation of resources from?society’s point of view, would generate an equilibrium where?MSB = MSC.?This can be found at?PoptQopt. There is?no market failure?at this equilibrium
• The free market is failing due to?over-provision?of this good/service at?Qe
• The factors of production used to manufacture this?over-provision?represent a?welfare loss to society?(pink triangle)
• To be?socially efficient, fewer factors of production should be allocated to producing this good/service
• There is an opportunity for?government intervention?(indirect taxes, legislation, regulation etc.), to force this market to be more?socially efficient
• Any intervention that?reduces the welfare loss?will be beneficial

• Positive externalities of consumption?are created during the consumption of a good/service (merit goods)
• The market is failing due to?under-consumption?of these goods/services as only the?private benefits?are considered by the consumers and not the external benefits
  • If the?external benefits?were considered, the quantity of the goods/services consumed?would increase?and they would be sold at a higher price

External benefits of consumption (positive externality) result in an under-consumption represented by the gap between Qe?and Qopt

Diagram Analysis

• MSC?is assumed to be equal to the?MPC?as the?focus is on the consumer?side of the market
• The free-market equilibrium can be seen at?PeQe. This is where the?MPB = MSC
• The larger the external benefits in consumption?(positive externality), the larger the gap between the MPB and MSB
• The?optimal allocation?of resources from society’s point of view would generate an equilibrium where?MSB = MSC.?This can be found at?PoptQopt.?There is no market failure here
• The free market is failing due to an?under-consumption?of this good/service at Qe
• More factors of production?should be allocated to producing the optimal quantity as?societal welfare will be gained?(pink triangle)
• There is an opportunity for?government intervention?(subsidies, partial provision etc.) to force this market to be more?socially efficient
• Any intervention that?gains welfare?will be beneficial

• Analysing?externalities?and the?government intervention?necessary to?correct them?is best done by considering?real world examples
• Analysis should always include the?impact on stakeholders including producers, consumers, government, and relevant third parties

The Impact of Negative Externalities & Government Intervention

The Impact of Positive Externalities & Government Intervention