2.3 Positive and Negative Externalities

Externalities are unintended effects of economic activities on third parties. They can be positive, like education boosting societal productivity, or negative, like pollution causing environmental damage. These effects create a gap between private and social costs or benefits.

This gap leads to market inefficiency, with negative externalities causing overproduction and positive externalities leading to underproduction. Understanding externalities is crucial for grasping market failures and the potential need for policy interventions to improve social welfare.

Externalities and Market Efficiency

Defining Externalities and Their Types

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• Externalities emerge as unintended effects of economic activities on third parties not directly involved in the transaction
• Positive externalities occur when social benefit exceeds private benefit, creating external benefits for society (education, vaccinations)
• Negative externalities arise when social cost surpasses private cost, imposing external costs on society (pollution, traffic congestion)
• Externalities categorize into production-related (affecting production process) or consumption-related (influencing consumer behavior)
• Positive externality examples
  • Education boosts societal productivity
  • Vaccinations contribute to herd immunity
  • Research and development generate knowledge spillovers
• Negative externality examples
  • Pollution causes environmental damage
  • Traffic congestion increases travel time for others
  • Secondhand smoke poses health risks to non-smokers

Impact on Market Efficiency and Social Welfare

• Externalities create divergence between private and social marginal costs or benefits, leading to market inefficiency
• Negative externalities result in market overproduction as true social cost remains unaccounted for in market price
• Positive externalities lead to market underproduction as full social benefit goes uncaptured in market price
• Presence of externalities generates deadweight loss, representing reduction in social welfare due to market inefficiency
• Externalities cause misallocation of resources as market prices fail to reflect true social costs or benefits accurately
• Efficiency loss magnitude depends on externality size and elasticity of supply and demand in affected market
• Addressing externalities through policy interventions potentially increases social welfare by internalizing external costs or benefits

Private vs Social Costs and Benefits

Divergence Between Private and Social Costs/Benefits

• Markets with externalities exhibit difference between private marginal cost (PMC) and social marginal cost (SMC), or private marginal benefit (PMB) and social marginal benefit (SMB)
• Negative externalities result in SMC exceeding PMC, encompassing both private and external costs
• Positive externalities cause SMB to surpass PMB, including both private and external benefits
• Graphical representation shows vertical distance between private and social cost/benefit curves
• Socially optimal production or consumption level occurs at SMC and SMB intersection, differing from market equilibrium at PMC and PMB intersection
• Area between private and social curves represents total external cost or benefit at any given quantity
• Divergence size between private and social costs/benefits determines extent of market failure and potential gains from policy intervention

Illustrating Cost-Benefit Divergence

• Negative externality example: Factory pollution
  • PMC represents factory's production costs
  • SMC includes production costs plus environmental damage costs
  • Vertical gap between PMC and SMC curves shows pollution's external cost
• Positive externality example: Beekeeping
  • PMB represents beekeeper's honey production benefit
  • SMB includes honey production benefit plus crop pollination benefit for nearby farmers
  • Vertical gap between PMB and SMB curves illustrates pollination's external benefit
• Mathematical representation:
  • For negative externalities: $SMC = PMC + MEC$ (where MEC marginal external cost)
  • For positive externalities: $SMB = PMB + MEB$ (where MEB marginal external benefit)

Market Failure from Externalities

Causes and Consequences of Market Failure

• Market failure occurs when free market fails to allocate resources efficiently, evident in presence of externalities
• Externalities create misalignment between private incentives and social welfare, leading to suboptimal decision-making by market participants
• Negative externality markets produce prices too low and quantities too high compared to social optimum
• Positive externality markets yield prices too high and quantities too low relative to socially efficient level
• Externalities violate assumptions of First Theorem of Welfare Economics, which states competitive markets lead to Pareto efficient outcomes
• Non-optimal resource allocation results from full social costs or benefits not incorporated into market prices
• Market failure due to externalities provides rationale for government intervention to correct resource misallocation and improve social welfare

Examples of Market Failure and Policy Implications

• Carbon emissions from industrial production (negative externality)
  • Market fails to account for climate change costs
  • Policy solution carbon tax or cap-and-trade system internalizes external costs
• Public health initiatives (positive externality)
  • Market underinvests in disease prevention programs
  • Government subsidies or direct provision can achieve socially optimal level
• Overfishing in international waters (negative externality)
  • Lack of property rights leads to overexploitation of fish stocks
  • International agreements and fishing quotas help address market failure
• Education (positive externality)
  • Private market underinvests in education due to unaccounted societal benefits
  • Public education funding and subsidies aim to achieve socially optimal education level