Externality

Introduction
Third party (or spill-over) effects arising from the
production and/or consumption of goods and services
for which no appropriate compensation is paid
Can cause market failure if social costs and social
benefits of production and consumption not accounted
Creates divergence between Private and Social cost of
production
Social Cost = Private Cost + Externality


 Positive and Negative
Externalities


 The effects of a decision by consumers and

producers that has an impact on a third party


Positive Externalities – beneficial effects

on third parties
Negative Externalities – costs incurred by
third parties

Costs and benefits in production:


External costs in production – where MSC =

MSB – MPC
 e.g. air and water pollution, congestion,

housing development on green belt areas,

destruction of hedgerows and wildlife,
noise, pollution, anti-social behaviour,
crime
External benefits in production – where MSC <
MPC
 e.g. human resource development, research

and development in industry



Costs and benefits in consumption:


External costs in consumption – where MSB <

MPB
 e.g. passive smoking, litter, noise,

anti-social behaviour
External benefits in consumption – where MSB
> MPB
 e.g. preventative health care – vaccinations,

public transport, attractive gardens, bathing

regularly!

External costs – socially efficient output is
less than current output
External benefits – socially efficient output
is greater than current output
Socially efficient output is where MSC +
MPC = MSB + MPB

 Measuring positive and negative externalities:

Consumer surplus
Producer surplus
Willingness to pay
Net Present Values
Risk values – probability of an event x
monetary value
Cost-Benefit Analysis

 Copyright: Karoly Feher and Drew Broadley, stock.xchng

Weighing up the costs and benefits

Benefits from production of
chemicals/pharmaceuticals and energy
Costs of generating these products/services

Network Externalities
Sometimes it helps if everyone uses the same
product or service. This may drive us
towards monopoly or standardization.
Somehow, this serious economic topic has
gotten bogged down in a lot of
personalities.
One problem is that defining standards can
both encourage the spread of technology
and limit the development of new
technology; so when to impose standards is
a difficult practical choice.

Network externalities are not the same as
economies of scale
“ Economy of scale” means that making many
copies of something is cheaper, per item, than
making a few.
“Network externalities” means that there are
benefits if many people use the same thing.
They both may encourage monopolies, but they
are different.

By the way, the phrase “network externalities”
was coined by Jeff Rohlfs, once at Bell Labs.

Specific examples
Having the only tennis racket in town is useless.
The more people that own tennis rackets, the
more useful they are. It doesn’t matter
whether it’s cheaper to make more rackets than
fewer rackets. This is a network externality.
Manufacturing many copies of the same digital
camera is cheaper, per camera, than making
only a few. It doesn’t matter whether people
benefit from all using the same camera. This
is an economy of scale.

 Externalities

Externalities in production


 (a) external costs

 External costs in production

MC = S
Costs and benefits

P D

O
Quantity Q1
 External costs in production
MSC
MC = S
Costs and benefits

P D

External cost

O
Social optimum Q2 Q1
Quantity
 Externalities in production
 (b) external benefits


 External benefits in production
MC = S
Costs and benefits

P D

O Q1
Quantity
 External benefits in production
MC = S MSC
Costs and benefits

External benefit

P D

O Q1 Q2
Social optimum
Quantity
 External costs and benefits in production

MSC MC = S MC = S MSC

Costs and benefits (£)

Costs and benefits (£)

External benefit

P D P D
External cost

O Q2 Q1 O Q1 Q2
Quantity Quantity

(a ) External costs (b) External benefits

Externalities in consumption


 (a) external costs

 External costs in consumption
Costs and benefits

P D

(MB)
MU = D

O Q1
Quantity
 External costs in consumption

External cost
Costs and benefits

P D

(MB)
MU = D
MSB

O Q2 Q1
Social optimum
Quantity
 Externalities in consumption
 (b) external benefits


 External benefits in consumption
Costs and benefits

P D

(MB)
MU = D

O Q1
Quantity
 External benefits in consumption

External benefit
Costs and benefits

P D

MSB

(MB)
MU = D

O Q1 Q2
Social optimum
Quantity
 External costs and benefits in consumption

Costs and benefits (£)

Costs and benefits (£)

External benefit

External cost
P P P P
MSB

MB MB
MSB

O Q2 Q1 O Q1 Q2

Car miles Rail miles

(a ) External costs (b) External benefits

 Using taxes to correct for an externality
 (a) external cost in production


 Using taxes to correct a market distortion
MC = S
Costs and benefits

P D

O Q1

Quantity
 Using taxes to correct a market distortion
MSC
MC = S
Costs and benefits

P D

External cost

O Q2 Q1
Social optimum
Quantity
 Using taxes to correct a market distortion
MSC
MC = S

Optimum tax = MSC – MC

Costs and benefits

P D

MC

O Q2 Q1

Quantity
 Using taxes to correct a market distortion
MSC
MC = S
Costs and benefits

P D

Amount of tax
MC

O Q2 Q1

Quantity
 Using subsidies to correct for an externality
 (a) external benefits in production


 Using subsidies to correct a market distortion
MC = S
Costs and benefits

P D

O Q1
Quantity
 Using subsidies to correct a market distortion
MC = S MSC
Costs and benefits

External benefit

P D

O Q1 Q2
Social optimum
Quantity
 Using subsidies to correct a market distortion
MC = S MSC

MC
Costs and benefits

Optimum subsidy
= MC – MSC

P D

O Q1 Q2
Quantity
 Using subsidies to correct a market distortion
MC = S MSC

MC

Amount of
Costs and benefits

subsidy
P D

O Q1 Q2
Quantity