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Definition
In the course of producing and consuming some commodities, harmful or beneficial side effects arise that are borne by firms and people not directly involved in the production or consumption of the commodities
These side effects are called externalities
2KING'S, MBA - 2015
contd.. An externality refers to the uncompensated
impact of one person’s actions on the well-being of a bystander
Externalities cause markets to be inefficient, and thus fail to maximize total surplus
An externality arises...when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.
3KING'S, MBA - 2015
Contd..
When the impact on the bystander is adverse, the externality is called a negative externality (Also called External Diseconomies)
When the impact on the bystander is beneficial, the externality is called a positive externality (Also called External Economies)
4KING'S, MBA - 2015
Contd..
Negative Externalities in Production Air pollution by the factories through
emitting smoke Waste of industries/factories poured into
streams or ocean create health hazard to those people who live in surrounding areas
Positive Externalities in Production Construction of a bridge or a highway which
reduces transportation costs and increases the land value in neighboring area.
5KING'S, MBA - 2015
Contd..
Negative Externalities in Consumption A loud music played by your neighbor may
disturb you and cause a lot of dissatisfaction Barking dog also create a negative externality
because neighbors are disturbed by the noise
Positive Externalities in Consumption If a person maintains a beautiful garden,
he/she not only increases his/her own satisfaction but also his/her neighbor enjoys the look of his/her garden.
6KING'S, MBA - 2015
Contd..
In negative externality
Social cost = private cost + external cost
Here external cost = cost to those people or firms affected by externalities
Cost is denoted by supply curve
7KING'S, MBA - 2015
Contd.. In positive externality
Social value = private value + external value
Here external value = value to those people or firms affected by externalities
Value is denoted by Demand curve
8KING'S, MBA - 2015
The Market for Commodity
Quantity of A0
Price of A
Equilibrium
Demand(private value)
Supply(private cost)
QMARKET
9KING'S, MBA - 2015
Contd..
In the presence of negative externality, the social cost of the good exceeds the pvt costs.
The optimal quantity, Qoptimum, is therefore smaller than the equilibrium quantity.
In other words, Negative externalities lead markets to produce a larger quantity than is socially desirable.
10KING'S, MBA - 2015
Negative Externality and the Social Optimum
Equilibrium
Quantity of A0
Price of A
Demand(private value)
Supply(private cost)
Socialcost
QOPTIMUM
Optimum
Cost of-ve externality
QMARKET 11KING'S, MBA - 2015
Contd.. The intersection of the demand curve
and the social-cost curve determines the optimal output level. The socially optimal output level is less
than the market equilibrium quantity. How to reduce equilibrium quantity?
The government can internalize an externality by imposing a tax to producer to reduce the equilibrium quantity to the socially desirable quantity.
KING'S, MBA - 2015 12
Contd.. In the presence of positive externality, the social
value of the good exceeds the pvt value.
The optimal quantity, Qoptimum, is therefore larger than the equilibrium quantity
In other words, Positive externalities lead markets to produce a smaller quantity than is socially desirable.
KING'S, MBA - 2015 13
Positive Externality and the Social Optimum
Quantity of A0
Price of A
Demand(private value)
Socialvalue
Supply(private cost)
QMARKET QOPTIMUM
14KING'S, MBA - 2015
Contd.. The intersection of the supply curve and
the social-value curve determines the optimal output level. The optimal output level is more than the
equilibrium quantity. The market produces a smaller quantity
than is socially desirable. The social value of the good exceeds the
private value of the good.
KING'S, MBA - 2015 15
Contd.. How to increase equilibrium quantity?
The government can internalize an externality by providing subsidies to the producer to increase the equilibrium quantity to the socially desirable quantity.
KING'S, MBA - 2015 16
Contd.. Government action is not always
needed to solve the problem of externalities
Private and Charitable Organizations can also solve the problem of externalities.
KING'S, MBA - 2015 17
Summary When a transaction between a buyer
and a seller directly affects a third party, the effect is called an externality
Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity
Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity
KING'S, MBA - 2015 18