Quick run through of externalities diagrams
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Externalities are unintended side effects of production or consumption that are experienced by third parties. They can lead to market failures if full social costs and benefits are not taken into account. With negative externalities, social costs exceed private costs, resulting in too much of the good being produced from a social perspective. Positive externalities occur when social benefits are greater than private benefits, leading to underproduction of the good from a societal point of view. Diagrams are used to illustrate the concepts of private optimum versus social optimum and the associated welfare losses that can result from externalities.
Quick run through of externalities diagrams
- 1. Quick Run Through of Externalities Diagrams AS Micro Economics Unit 1
- 2. What are externalities? • Externalities are third party ‘spill-over’ effects arising from production and consumption of goods and services for which no appropriate compensation is paid • They can cause market failure if the price mechanism does not take into account the full social costs and benefits of production and consumption • Externalities occur outside of the market i.e. they affect economic agents not directly involved in the production and/or consumption of a good or service
- 3. Private and Social Costs • Private Costs – Are paid only by the producer or consumer concerned – They are internal costs of production or consumption • Social Costs – Social Cost = Private Cost + External Cost – Negative externalities add to social costs or reduce social benefits – We assume that the consumer and/or producer does not take external costs into account when making decisions – This can lead to a misallocation of resources (causing a loss of allocative efficiency) – This means that social welfare is not maximized - a cause of market failure
- 6. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost External cost
- 7. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost Marginal private benefit = marginal social benefit
- 8. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost Marginal private benefit = marginal social benefit Q1 External cost
- 9. Quantity Costs Benefits NEGATIVE EXTERNALITIES Marginal private cost Marginal social cost Marginal private benefit = marginal social benefit Q1Q2 A External cost A Private optimum
- 10. Quantity Costs Benefits NEGATIVE EXTERNALITIES Q1Q2 B A A Private optimum B Social optimum Marginal social cost Marginal private cost Marginal private benefit = marginal social benefit
- 11. Quantity Costs Benefits NEGATIVE EXTERNALITIES MPC MSC MPB = MSB Q1Q2 A Private optimum B Social optimum Social welfare loss
- 12. Positive Externalities • Private benefits – The utility derived from consumption (for a consumer) – The revenue accruing to a producer • Social benefit – Social benefit = Private benefit + External benefit • With positive externalities, social benefit > private benefit
- 14. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit External Benefit
- 15. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost
- 16. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost A Private optimum A
- 17. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost A Private optimum A B Social optimum B
- 18. Quantity Costs Benefits POSITIVE EXTERNALITIES Marginal Private Benefit Marginal Social Benefit Marginal Private Cost A Private optimum A B Social optimum B Welfare loss from under- consumption