What are externalities?
Externalities are common in virtually every area of economic activity.
They are defined asthird party (or spill-over) effects arising from
the production and/or consumption of goods and services for which no
appropriate compensation is paid.
Externalities can cause market failure if the price mechanism does not
take into account the full social costs and social benefits of
production and consumption.
The study of externalities by economists has become extensive in
recent years - not least because of concerns about the link between
the economy and the environment.
PRIVATE AND SOCIAL COSTS
Externalities create a divergence between the private and social costs
Social cost includes all the costs of production of the output of a
particular good or service. We include the third party (external)
costs arising, for example, from pollution of the atmosphere.
SOCIAL COST = PRIVATE COST + EXTERNALITY
For example: - a chemical factory emits wastage as a by-product into
nearby rivers and into the atmosphere. This creates negative
externalities which impose higher social costs on other firms and
consumers. e.g. clean up costs and health costs.
Another example of higher social costs comes from the problems caused
by traffic congestion in towns, cities and on major roads and motor
It is important to note though that the manufacture, purchase and use
of private cars can also generate external benefits to society. This
why cost-benefit analysis can be useful in measuring and putting some
monetary value on both the social costs and benefits of production.
MARKET FAILURE AND EXTERNALITIES
When negative production externalities exist, marginal social cost>
private marginal cost. This is shown in the diagram below where the
marginal social cost of production exceeds the private costs faced
only by the producer/supplier of the product. In our example a
supplier of fertiliser to the agricultural industry creates some
external costs to the environment...