Externalities
Negative Consumption Externality
A negative consumption externality occurs when the by-product from the consumption of a good is viewed to have a social cost. For instance, a good that generates negative externalities from its consumption would be cigarettes. When a person smokes, while he/she incurs his/her own cost (marginal private cost) which includes the cost of cigarettes and the damage to their health, the general public also inhales second-hand smoke. However, even though 2nd hand smoke can have very harmful effects on other people, individuals generally do not account for this in the costs of smoking, such as the medical fees of the third parties who contract lung diseases. Instead, society, in general, has to pay for the costs of dealing with 2nd hand smoke, including the loss in labour efficiency due to absenteeism. Therefore, smoking results in a negative externality that is unpriced by the free market.
This implies that a negative externality occurs when the social cost is greater than the private cost. Hence, as seen in the diagram below, the marginal social cost lies above the marginal private cost, since MSC = MPC + MEC. If the two values were the same, then there would not be a negative externality.
The externality is created because the marginal social cost (MSC) is greater than the marginal private cost (MSC). However, since the free market does not price in the marginal external cost of consuming an additional unit of cigarettes, the equilibrium price and output are set at where MPC=MPB, which is Pm and Qm respectively. On the other hand, the socially optimum output is actually Qs, where MSC=MSB. Therefore, while society would like consumption levels kept at Qs, there is an overconsumption of Qm-Qs units of cigarettes and an inefficient allocation of resources. With the overconsumption of Qm-Qs units of cigarettes, the total social costs incurred outweighs the total social benefits gained, hence resulting in a deadweight welfare loss of area ABC.
Refer to the video for diagrams
Positive Production Externality
Positive production externalities exist when the marginal social benefit of production exceeds the marginal private benefits i.e. production of the good generates external benefits that are under-valued by the free market. For instance, something that generates positive externalities from its production is honey. When a beekeeper produces honey, he/she incurs his/her own cost (marginal private cost) which includes the cost of breeding bees and labour needed to extract honey from beehives, as well as enjoys his/her own benefits (marginal private benefit) which includes revenue generated from the sale of honey. However, the production of honey also benefits third parties who are neither consumers nor producers of honey. Farmers nearby benefit from plant pollination by honey bees which increases their yield in orchards. Nevertheless, producers do not enjoy these additional benefits brought about by society and hence do not account for this in their decision-making process. As such, honey production results in a positive externality that is unpriced by the free market. This implies that a positive externality occurs when the social benefit is greater than the private benefit. Hence, as seen in the diagram below, the marginal social benefit lies above the marginal private benefit, since MSB = MPB + MEB. If the two values were the same, then there would not be a positive externality.
The externality is created because the marginal social benefit (MSB) is greater than the marginal private benefit (MPB). However, since the free market does not price in the marginal external benefit of producing an additional unit of honey, the equilibrium price and output are set at where MPC=MPB, which are Pm and Qm respectively. On the other hand, the socially optimum output is actually Qs, where MSC=MSB. Therefore, while society would like production levels kept at Qs, there is an underproduction and hence underconsumption of Qs-Qm units and an inefficient allocation of resources.
Refer to the video for diagrams
Other examples of economic activities that can generate positive externalities include:
Industrial training by firms: This does not only benefit the firms carrying out the training but also society as a whole. With the growth in labour productivity, more output can be produced with the same amount of resources, increasing the quantity and quality of the goods available for consumption, hence improving living standards throughout the economy.
Research into new technologies: This does not only benefit the firms carrying out the research but also society as a whole. The research can be disseminated for use by other producers not involved in the research process. These technology spill-over effects are able to lower the cost of production for many producers, which leads to lower prices for consumers, benefiting them and hence improving living standards throughout the economy. (You can read more about how research into space technology has resulted in many spillover technologies used in consumer electronics today)
Education: Education does not only benefit the people getting an education but everyone else as well. An educated person is able to share what he/she learnt with the people around him/her. With a more educated workforce, its productivity will increase and hence improving the state of the economy. Besides just improving the living standards throughout the economy, these efficiencies can help in the attainment of many macroeconomic goals.
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