Externalities: Social Benefits and Social Costs - Online Tutor, Practice Problems & Exam Prep

Externalities are costs or benefits imposed on innocent bystanders not involved in a transaction. Negative externalities, like pollution from a factory, lead to overproduction and market failure, while positive externalities, such as education, result in underproduction. The marginal social cost (MSC) and marginal social benefit (MSB) curves illustrate these concepts, highlighting the need for efficient market outcomes. Property rights play a crucial role in internalizing externalities, influencing how costs and benefits are distributed within society.

Negative Externality and Positive Externality

So, have you ever been woken up at night by a loud barking dog, or maybe it's your dog keeping your neighbors up? Maybe you're just wondering what any of this has to do with economics. Well, let's dive into the topic of externalities and we'll see. In this unit, we're going to talk about externalities and basically what I want you to think about is we're going to extend the idea of cost and benefit to the whole society. Before, we've only been thinking of the people in the transaction, right? The buyer and the seller. Now, we're going to think of the benefit to society as a whole and the cost to society as a whole, alright? And this is going to include these ideas of externalities. Okay. So, what we're going to see is that sometimes these market transactions between a buyer and a seller are going to impose some sort of cost or benefit on someone which I call an innocent bystander, someone who has nothing to do with the transaction, okay? And we're going to see that this can either be a good thing, like a benefit to those outsiders, or a bad thing, a cost. Alright, so let's talk about both of those. We're going to start here with the negative externalities and I'm going to define a couple of things before we get to our examples, so just stick with me and then we'll get there.

So, first, we got a negative externality, right? We hear negative externality. We're going to impose a cost onto these innocent bystanders. First, we have what's called the private cost. Okay, this private cost is what we're used to. This has been the supply curve that we've seen in previous units and stuff, right. We've seen the supply curve. The cost to the seller to produce something creates the supply curve. And compare that to what we're going to be talking about now is this social cost, right. Remember I'm saying we're going to extend the cost and the benefit to society as a whole, right? And we'll see that on a graph, but the idea here is that this social cost, right, it's going to include the private cost, so the cost we're used to from the supply curve, but now we're going to add something to that cost which is this external cost, right? And this is cost to people outside the transaction. All right, so when we're talking about externalities, instead of having a supply curve, what we're going to have is this marginal social cost curve, okay, and this is kind of like the supply curve plus, right? This is kind of like supply curve 2.0 where we're going to have, not only those private costs, but we're going to have these external costs, right? We're going to be showing that social cost on the curve. So we're going to use this acronym MSC. Cool? So let's go ahead and do some examples of negative externalities to kind of bring this all together.

The first one here is a very common example to help you understand this is we think of a paper production factory, okay? So, this factory, it's sitting on a lake, right and this factory like we're used to, they produce paper, right? So their private costs could include things like cutting down the trees and processing them into paper, right? So, kind of just like the standard cost we might be used to in a paper production facility. Pollutants enter the lake during the production process, right? It's kind of just like a byproduct of production is these chemicals, right? This pollution it's putting into the lake and let's say there's a bunch of houses right on the other side of the lake, that now they have to deal with this pollution, right? This cost is being put onto these people who live in these houses, this pollution in their lake, is a cost to these residents. So, I'm gonna say this external cost is the pollution, right, to those residents. So you'll see that now we're extending it, right, not just the cost to the seller, those cutting tree costs, but now also the cost to everybody, right? This pollution.

So, let's go back to that example from the beginning, the dog. Right? So how does this relate to the externalities? We have the idea that you've got private costs for keeping a dog, right? Maybe you got to feed the dog, getting it a bed or whatever, but then there's this external cost, right? In this case, we've got this loud dog. It doesn't stop barking all night and it's keeping the whole neighborhood awake. Right? So we could say that the external cost here is your neighbor's happiness. Right? There's a cost to your neighbor's happiness, that you weren't accounting for when you bought the dog yourself, right? You weren't thinking, "Oh, how much is this going to affect my neighbor's sleep schedule?" Probably not your first thought when you got the dog. And yet here we see an external cost for a dog, but I could probably make an argument for an external benefit for a dog too, right? Maybe the whole neighborhood's happier because there's a cute little puppy running around, but in this case, it's an annoying dog making a lot of noise and it's affecting everybody in a negative way, right? So that's kind of how you see these external costs. We're kind of looking beyond just the people inside the transaction, right? We're going to extend it beyond that to the whole society. So let's go ahead and see a positive externality, right? This is going to be pretty much the opposite of what we just saw, right?

So before we with a negative, right, we were imposing a cost onto these innocent bystanders. Now a positive externality, which I'll just use this plus sign. So sorry. I didn't mention it up here, but I'll put a little negative sign when I'm talking about negative externalities later, and I'll, you know, put it next to things I'm talking about or a little plus sign for the positive ones. So positive externality, a little plus sign, and this is going to create a benefit to the bystanders, right? So it's not all bad. Externalities can be good as well, right? This can put a benefit onto innocent bystanders. So just like before, we'll have a couple of definitions, and you'll see how similar they are. We've got the private benefit, right, and this is what we're used to. When you think about buying something on the market, that demand curve, that stands for your private benefit, right? You're thinking about your private benefits when you consider buying something, right? So maybe you're going to the store to buy a pack of gum, right, and you're thinking you're not thinking about, "Oh, how is this pack of gum going to affect everyone else?" You're like, "No, I'm just one pack of gum, I want to chew gum," and you buy it, right? That's going to be that private benefit you're getting and that's the demand curve that we're used to, just like the private cost was the supply curve we're used to. So then you can imagine that this other one is going to be the social benefit, right? So that social benefit is going to include our demand curve that we're used to plus that external benefit from the externality, right? So you can see kind of the similarities here. We're going to have like that demand curve 2.0, right, where we're looking at the whole society's benefit not just your benefit. So it's going to be kind of like the demand curve plus more benefits. Cool. So we're going to see here just like we had the marginal social cost curve, this marginal social benefit curve, MSB, is going to be like that demand curve 2.0, right, and we're going to see both of these on the graph in just a second. So let's go ahead and do some examples of these positive externalities.

The first very common example is vaccinations, right? So when you go to the doctor and get a vaccine, you have the private benefit of not getting sick, right? You went to the doctor because you're not going to get sick when you get this vaccine, right? You're now vaccinated against the disease. It's not going to happen to you, but most of the times when we get vaccinated, it's usually for some sort of contagious disease like, I don't know, measles or something, right? So the fact that you got vaccinated actually is a benefit to everyone around you, right? Because you're less contagious. So, since you can't catch the disease, it makes it so it's less likely for everyone else to catch the disease as well. So this external benefit is kind of like having a less contagious population, right? So fewer people in the population can get sick and pass it on to other people, right? So there's that external benefit, right, that's beyond you, that's not just you anymore, right? You got the benefit of not being sick, but the whole society has less of a chance of being sick now. Cool? So, see another really common one here is education. I'm going to scoot out of the way and let's do this one. So private benefit, right, when you went to college, you're probably thinking about the private benefits of an education. You're, you know, you're thinking, "Oh, I'll make more money," right? If I get a college education, I'll be able to get a higher-paying job, something like that, or maybe you just wanted to be a lot smarter, but in this case, let's say you did it because you wanted more money, right? More education meant you'd get a higher salary. But there are external benefits to you being smarter too. It's been shown that education, right? When people are more educated, we're going to be more productive. So you can imagine that a country that is full of educated people is going to have more productivity than a country that has no education, right? So we're going to say we're going to have a more productive population, right? And you're going to get external benefits from this, right or the society gets external benefits from your education, right? So we're going to see that in general, a more productive population exists from your education, right? So when you do a service for me because you're educated, you're going to do it more efficiently and stuff and I'm going to get a benefit because you got educated, right? So something like that and so that's kind of the idea here with these externalities, right? You can see the negative and the positive externalities and I want to make a quick point before we move on to these graphs. If you look at these external costs and these external benefits that we've discussed so far, they're kind of intangible, right? They're kind of weird things like an external cost of pollution, right? Like how much does, you know, how do we quantify like the cost of this pollution into the lake affecting the people living on the lake, right, like how do we account for what this does to their happiness or a dog barking, how does that affect the neighbor's happiness in dollars, right? Or how do we quantify a less contagious population? So you can see that these things are kind of like weird concepts, so in practice you can see that it's going to be kind of difficult to deal with externalities, but when we're dealing with it in theory here like we're going to do on the graphs, we can kind of make some conclusions just based on the ideas here. Alright, so let's go ahead and go on to the next video and we'll see these externalities on the graph. Let's do that now.

Externalities on the Graph

All right, let's see what these externalities look like on the graph. Let's start here with the negative externality and our example of that paper production company. So the company has a factory on a lake and it dumps chemicals into the lake. On the same lake, there are residents living on the other side, right? They are affected by these chemicals polluting their lake, which affects their quality of life. Cool? Let's see what it looks like on the graph. Here we're going to start with what we're used to. We've got our D1 here, downward demand, S1 upward supply, right? We've got our price axis with the price of paper and quantity of paper down there, right? So we've got what we're used to and here, this quantity of the market, right? So the market here is at an equilibrium, we are going to say it's at equilibrium, but the fact is that this market isn't including all of our costs, right? We've got this cost of pollution. This S1 that we see here, this is the private cost, right? It includes the costs you'd expect a paper company to include in their costs like cutting down the trees and processing them, you know, those types of things are included in this cost curve. But what they didn't include is the cost of pollution, right? They're not including that in their cost when figuring out how much to charge, right? How much to supply. So what happens when there's more cost? If you remember from our shifts when we were shifting supply and demand, well, when we had additional costs, those additional costs shifted supply to the left, right? So when we think of supply, we're going to think of all the costs to society, not just the cost to the supplier, but those external costs too. And the demand curve will include those private benefits that we're used to in the demand curve plus these external benefits, right? So the picture we're trying to paint is society as a whole. So if S1 is there, we've got our private cost, but now we've got this additional cost from the externality. So we're going to have to draw our new supply curve, which is not really a shift. I don't want you to think we're shifting the supply curve to the left. What we're doing is showing the true cost, right? We've essentially shifted to the left, but what we're showing is that we've got an extra cost. This curve already existed; it's just that we didn't show the pollution in our original curve. It's not like now the market shifted to this new position. We're not at the correct equilibrium because we're not accounting for that cost. So this extra shift represents that extra cost from pollution, and we've got here S2, right? And this is going to be our marginal social cost curve. So the cost of the pollution exists now; let's see what that really means in our market. The real equilibrium, Q*, this is the efficient equilibrium if we were to account for all costs and all benefits, would be right there and our efficient price would be somewhere here. But I want to focus on this quantity, the important part. We're overproducing in this case because we're not accounting for all our costs. The market, when we don't consider this pollution, is going to be producing here at this QM, which I'm calling QM like Q market, right? And that PM is that price on the market. But it's an equilibrium that we've reached, but it's a wrong equilibrium because it doesn't account for all our costs. So in that case of the negative externality, we're producing too much because we're not accounting for all our costs. We end up over producing, right? And anytime we're not at our efficient equilibrium, we have deadweight loss, right, inefficiencies, it's not a good thing. We want to be at that efficient equilibrium; in this case, the negative externality keeps us from it.

Let's see what happens with a positive externality. Here you might be thinking positive externalities, that's a good thing, right? Extra productivity in our society and less contagious population, these are all good things, and you're right. So just like before, we've kind of got our standard situation where we've got D1 here and S1, and we've got our original equilibrium there, right? And remember, this isn't going to be our efficient equilibrium because we're not accounting for all our costs and benefits. In this case, we're talking about education, right? We discussed how education creates this extra benefit of a more productive population, right? So there's this external benefit to people outside just you getting the education or the university education; everyone else is also benefiting. So what do you think is going to happen? When we had an extra cost, we shifted supply to the left. Now we have an extra benefit. So this is an extra good thing, right? And we are here, when we talk about benefits, we're going to move with the demand curve, right? The demand curve is going to represent our benefits. So here with D1, we had our private benefits, right? And that's what we're used to, when we think about college you know when you were considering going to college, you were probably sitting there, you're like, "If I go to college, you know our whole country will be way more productive". You probably weren't thinking like that, right? You were probably thinking about "If I go to college, you know, I'll get a higher paying job, I'll be more specialized", right? You don't think about these external benefits, but they do exist. So in this case, since we have extra benefits, the demand curve is going to shift to the right, right, because this is a good thing. In the other case, we had a bad thing, so we shifted to the left. Here, it's a good thing, and we say we put our benefits on our demand curve, so the demand curve will shift to the right. We're going to have this new demand curve. And remember all these things are quite intangible, right? It's kind of hard to say how much extra benefit we get from this more productive society; it's really hard to say, so here it's easy, you know, we can just put an estimate, but in real life, you can see it could be kind of hard to deal with this in practice. We've got D2 now, right? We've shifted to the right and this D2 is going to be our marginal social benefit curve. This includes all of our benefits, right? Not only the private benefit you get from going to college, but the benefit you put on everyone else because you're smarter. Let's see what happens here. We've got our original equilibrium which had that Q market, right? And that price on the market. So although this is an equilibrium, this isn't our efficient equilibrium because we weren't accounting for all costs and benefits. So if we go here, this is our true equilibrium, the efficient equilibrium, and let's look at our quantity here. Our quantity would be somewhere up here. Q*, our efficient equilibrium, and our price something like this, but let's focus on quantity again. That's the real kicker here. The market by itself is not going to produce the efficient quantity, right? We are under the efficient quantity; in this case, we're underproducing. When we leave the market to do its own thing, it doesn't account for these extra benefits, and it underproduces this education. You'll see that we were thinking, "Oh, this is a positive thing, right, People are smarter", but what ends up happening is we're not providing enough education, as the market wants, right? And that's because we don't consider this extra benefit. In these cases, you'll see like the government can step in and help the market reach that equilibrium quantity. But let's make our conclusions here. The first thing is that we're going to see that externalities are going to cause market failures. Positive and negative, regardless of which kind of externality it causes a market failure, and remember that's just an inefficient market. Anytime we're inefficient, we have a market failure. So in the case of a negative externality, we were overproducing; we weren't at our equilibrium quantity, we're inefficient anytime we're not at equilibrium, so our overproduction was in the case of a negative externality, and we had underproduction in the case of a positive externality. In both cases, we're not efficient, and anytime we have this market failure, we've got a deadweight loss, right? And when we talk about externalities, we're not going to be calculating the deadweight loss as much or anything like that, but I still want to point it out to you on the graph just so you see where it is. It'll help your intuition here too with deadweight loss. So when we talk about deadweight loss, we have to look at our equilibrium point and then we've got that bow tie of deadweight loss and we gotta pick which side we should be on. So what's tricky here is that our equilibrium is actually this point up here right? The one where our marginal social cost curve crosses, right? So what we're going to see is that we're overproducing; we should be producing at that point, that quantity, but we're actually up at this quantity. So we're going to see that this overproduction causes this deadweight loss up here, right? So a lot of you might have thought that the deadweight loss would have been somewhere around here or in here, right? That's wrong because our equilibrium is this point up here. So we're not going to calculate or anything; I just kind of want to point it out to you. So if that's the case there, where do you think the deadweight loss is going to be on our positive externality?

Well, we're going to start again at our equilibrium, right? And this is our true equilibrium, Q* here, and this time we're underproducing, right? So we want to be at that star, but we're only trading here at QMarket. So everything here didn't happen, right? We're not making these trades even though they're efficient for society. So that surplus between QMarket and QStar was lost, right? We didn't get it. That's the deadweight loss. All right? So that's where they are on the graph. Don't worry about it too much; I just wanted to point it out to you. The last thing here is that why do externalities exist? And the main reason here is that we have property rights that are either not clearly defined or difficult to enforce, okay? So property rights are kind of like the backbone to this issue. It's pretty easy to explain with that paper production facility. It's true in the case of positive externalities too, but it gets a little more intangible, tricky. But let's talk about this negative; it'll make sense. So in this case of this production factory, right? And they're polluting the lake that these people live on. So let's say that in the first scenario, the company owns the lake, right? The factory that produces the paper owns the lake as well. Well, in this case, there's no problem, right? They own the lake; they're allowed to pollute it, so there's not really an externality here. It's the resident's fault for choosing to live on this lake that this company owns, right? So they should have known about that when they bought that house. All right, so if the company owns the lake then they're allowed to pollute it, right? There's no externality there. But what if the people own the lake?

If the production of a good causes a negative externality, then the social-cost curve will lie ________________ the supply curve, and the socially optimal quantity is _________________ than the equilibrium quantity.

• A. Above; Greater
• B. Above; Less
• C. Below; Greater
• D. Below; Less

Here’s what students ask on this topic:

What are externalities in economics?

Externalities are costs or benefits that affect third parties who are not directly involved in a transaction. They can be either negative or positive. Negative externalities, such as pollution from a factory, impose additional costs on society, leading to overproduction and market inefficiency. Positive externalities, like education, provide additional benefits to society, resulting in underproduction if left to the market alone. Understanding externalities is crucial for addressing market failures and achieving efficient outcomes.

How do negative externalities lead to market failure?

Negative externalities lead to market failure by imposing additional costs on innocent bystanders that are not reflected in the market price. For example, a factory that pollutes a lake imposes a cost on nearby residents. This results in overproduction because the market equilibrium does not account for the external costs. The marginal social cost (MSC) curve, which includes both private and external costs, shows that the true cost of production is higher than the private cost, leading to inefficiency and deadweight loss.

What is the difference between private cost and social cost?

Private cost refers to the costs incurred by the producer or seller in a transaction, which are typically represented by the supply curve. Social cost, on the other hand, includes both the private cost and any external costs imposed on society. The social cost is represented by the marginal social cost (MSC) curve, which accounts for the total cost to society, including negative externalities like pollution. Understanding the difference helps in identifying market inefficiencies and the need for regulatory interventions.

How do positive externalities affect market outcomes?

Positive externalities result in benefits to third parties not directly involved in a transaction. For instance, education not only benefits the individual but also society by creating a more productive population. However, the market tends to underproduce goods with positive externalities because the private benefits do not capture the full social benefits. The marginal social benefit (MSB) curve, which includes both private and external benefits, shows that the true benefit to society is higher than the private benefit, leading to underproduction and inefficiency.

What role do property rights play in addressing externalities?

Property rights are crucial in addressing externalities because they help internalize external costs and benefits. When property rights are clearly defined and enforceable, parties can negotiate to reach an efficient outcome. For example, if residents own a lake, they can negotiate with a polluting factory to compensate for the pollution. This internalizes the external cost, aligning private costs with social costs. However, when property rights are unclear or difficult to enforce, externalities persist, leading to market failures.