Externalities
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Intros
Lessons
- Externalities Overview
- Externality Definition & Types
- Definition of Externality
- Positive & Negative Externality
- Positive & Negative Production Externalities
- Positive & Negative Consumption Externalities
- Private, External, Social Cost
- Private & Marginal Private Cost
- External & Marginal External Cost
- Social & Marginal Social Cost
- Marginal Social Cost (MSC) = MC + Marginal External Cost
- Effects of Negative Externalities
- Marginal External Cost & Marginal Social Cost
- Market Equilibrium
- Socially Optimal Output
- Overproduction of output
- Deadweight Loss from Overproduction
- Benefit, & Social Benefit
- Positive Externalities
- Private Benefit & Marginal Benefit
- Social Benefit & Marginal Social Benefit
- Effects of Positive Externalities
- Market Equilibrium
- Socially Optimal Output
- Underproduction of Output
- Deadweight Loss from Underproduction
Examples
Lessons
- Negative externalities create a ________, and positive externalities create a __________.
- Benefit, benefit
- Benefit, cost
- Cost, benefit
- Cost, Cost
- Which is not an example of negative consumption externality?
- Smoking cigarettes in public.
- Creating a product that creates pollution.
- Littering.
- Not cleaning up household wastes.
- None of the above.
- Questions Relating to Marginal Private/Social Benefits & Costs
The following table shows the marginal benefits that Sam and Devin receive from police officers on duty during work hours at their firm.
Police officers on duty (number of days) Marginal Benefit Sam Devin 1 25 30 2 20 25 3 15 20 4 10 15 5 5 10
If Sam and Devin are the only people at work, then graph the marginal social benefit. - The following table provides costs and benefits that occur from a firm production that pollutes a lake used by fishers.
Output of production Marginal cost Marginal external cost Marginal social benefit 0 0 0 150 1 5 15 125 2 15 30 100 3 30 45 75 4 50 60 50 5 75 75 25 - The following table provides costs and benefits in a society for a certain production.
Output of production Marginal social cost Marginal private benefit Marginal external benefit 0 0 30 45 1 5 25 40 2 10 20 35 3 15 15 30 4 20 10 25 5 25 5 20 - The follow table shows the data on a wildlife anti-extinction program.
Output of Fences Marginal Social Cost Benefit 1 3 15 2 6 12 3 9 9 4 12 6 5 15 3
Topic Notes
Introduction to Externalities
Externalities are a crucial concept in economics, representing the unintended effects of economic activities on third parties not directly involved in the transaction. These spillover effects can be positive or negative, significantly impacting society and market efficiency. Our introduction video provides a visual overview of this important topic. In this article, we'll delve deeper into externalities, exploring their definition, various types, and far-reaching effects on economic systems and policy-making. Understanding externalities is essential for economists, policymakers, and businesses alike, as they play a pivotal role in shaping market dynamics and influencing decisions on resource allocation. By grasping the concept of externalities, we can better comprehend market failures, develop effective regulations, and work towards more sustainable economic practices. Join us as we unpack this fundamental economic principle and its implications for our interconnected world.
Understanding Externalities: Definition and Types
Externalities play a crucial role in economic decision-making and market dynamics. An externality is defined as the unintended impact of an economic activity on third parties not directly involved in the transaction. These effects can be either positive or negative and can significantly influence resource allocation and social welfare. Understanding externalities is essential for policymakers, businesses, and individuals to make informed decisions and address market inefficiencies.
There are four main types of externalities: negative production, positive production, negative consumption, and positive consumption. Each type has distinct characteristics and implications for economic outcomes.
Negative Production Externalities
Negative production externalities occur when the production of a good or service imposes costs on third parties that are not reflected in the market price. A classic example is pollution from a factory. The factory produces goods for consumers, but the pollution it generates affects the surrounding community's air and water quality. The cost of this pollution is not factored into the price of the products, leading to an overproduction of the good from a social perspective.
Positive Production Externalities
Positive production externalities arise when the production of a good or service benefits third parties without them paying for those benefits. An example is a company investing in research and development (R&D). While the company aims to improve its products, the knowledge generated from R&D can spill over to other firms or industries, fostering innovation and economic growth. Since the company cannot capture all the benefits of its R&D investment, there may be underinvestment in such activities from a societal standpoint.
Negative Consumption Externalities
Negative consumption externalities occur when the consumption of a good or service imposes costs on third parties. Secondhand smoke is a prime example. When individuals smoke in public spaces, they impose health risks on non-smokers nearby. The smokers do not bear the full cost of their consumption, leading to overconsumption of cigarettes from a social perspective.
Positive Consumption Externalities
Positive consumption externalities arise when the consumption of a good or service benefits third parties who do not pay for those benefits. Education is a classic example. When individuals pursue higher education, they not only improve their own prospects but also contribute to a more skilled workforce, increased productivity, and potentially lower crime rates. These societal benefits are not fully captured in the private decision to pursue education, potentially leading to underinvestment in education from a social perspective.
Understanding these types of externalities is crucial for addressing market failures and designing effective policies. For negative externalities, governments may implement regulations, taxes, or public provision of goods and services may be used to encourage activities that generate social benefits.
Externalities challenge the notion that free markets always lead to efficient outcomes. They highlight the importance of considering broader societal impacts in economic decision-making. By recognizing and addressing externalities, policymakers can work towards more sustainable and equitable economic systems that balance private interests with social welfare.
In conclusion, externalities are a fundamental concept in economics that helps explain why market outcomes may not always align with societal interests. By categorizing externalities into negative production, positive production, negative consumption, and positive consumption, we can better analyze their impacts and develop targeted solutions. As global challenges like climate change and public health crises demonstrate, understanding and addressing externalities is more critical than ever for creating resilient and sustainable economies.
Private, External, and Social Costs
Understanding the concepts of private cost, external cost, and social cost is crucial in economics and environmental studies. These concepts help us grasp the full impact of economic activities on society and the environment. Let's delve into each of these costs and their marginal counterparts to gain a comprehensive understanding of how they relate to externalities.
Private cost refers to the expenses incurred directly by an individual or a firm in the production or consumption of goods and services. These costs are typically reflected in the market price of a product or service. For example, when a company manufactures a car, the private costs include raw materials, labor, and overhead expenses. Private costs are borne solely by the producer or consumer and do not directly affect third parties.
External cost, also known as externality, is the cost or benefit that affects a third party who did not choose to incur that cost or benefit. These costs are not reflected in the market price of a good or service. A classic example of an external cost is pollution. When a factory releases harmful emissions into the air, it creates health problems for the local community, which bears the cost of medical treatments and reduced quality of life. These costs are not factored into the price of the factory's products.
Social cost is the sum of private cost and external cost. It represents the total cost to society of producing or consuming a good or service. In other words, social cost encompasses all the costs associated with an economic activity, including those borne by third parties. Using the factory example, the social cost would include both the production costs (private cost) and the health and environmental costs imposed on the community (external cost).
To better understand how these costs change with production or consumption levels, we need to consider their marginal counterparts. Marginal cost refers to the additional cost incurred by producing one more unit of a good or service. This concept applies to private, external, and social costs.
Marginal private cost (MPC) is the additional private cost incurred by producing one more unit of a good or service. For a car manufacturer, this might include the cost of additional materials and labor needed to produce one more car. MPC typically increases as production increases due to factors like resource scarcity and diminishing returns.
Marginal external cost (MEC) is the additional external cost imposed on society by producing one more unit of a good or service. In the case of the polluting factory, the MEC would be the incremental harm caused to public health and the environment by increasing production by one unit. MECs can vary greatly depending on the nature of the externality and the current level of production.
Marginal social cost (MSC) is the sum of marginal private cost and marginal external cost. It represents the total additional cost to society of producing one more unit of a good or service. The MSC takes into account both the direct costs to the producer and the indirect costs imposed on third parties. Understanding MSC is crucial for policymakers and economists when determining the optimal level of production that maximizes social welfare.
The relationship between these costs and externalities becomes clear when we consider real-world examples. Take the case of a coal-fired power plant. The private costs include the cost of coal, labor, and equipment maintenance. However, the plant also emits greenhouse gases and other pollutants, creating external costs in the form of climate change impacts and health issues for nearby residents. The social cost of electricity production from this plant would be significantly higher than the private cost alone.
Another example is the use of pesticides in agriculture. While pesticides increase crop yields (a private benefit), they can also harm beneficial insects, contaminate water sources, and pose health risks to farm workers and consumers. These negative externalities contribute to the external cost, making the social cost of pesticide use much higher than the private cost to the farmer.
Understanding these cost concepts is essential for addressing market failures and implementing effective policies. When external costs are significant, the market price of a good or service does not reflect its true cost to society. This can lead to overproduction and overconsumption of goods with negative externalities. Policymakers can use tools like taxes, subsidies, or regulations to internalize external costs and align private incentives with social welfare.
In conclusion, the concepts of private cost, external cost, and social cost, along with their marginal counterparts, provide a framework for analyzing the full impact of
Analyzing Negative Externalities
Negative externalities play a significant role in shaping market equilibrium and economic efficiency. These externalities occur when the production or consumption of a good or service imposes costs on third parties not directly involved in the market transaction. Understanding the effects of negative externalities on market equilibrium is crucial for policymakers, economists, and businesses alike.
In a perfectly competitive market without externalities, the equilibrium price and quantity are determined by the intersection of supply and demand curves. However, when negative externalities are present, the market equilibrium fails to account for the full social cost of production or consumption. This leads to a divergence between private costs and social costs, resulting in market inefficiency.
To graphically represent negative externalities using supply and demand curves, we need to consider both the private supply curve and the social supply curve. The private supply curve reflects the marginal private cost (MPC) of production, while the social supply curve incorporates both the private cost and the external cost, representing the marginal social cost (MSC).
On a graph, the private supply curve (S) is typically drawn as an upward-sloping line, reflecting the increasing marginal cost of production. The demand curve (D) represents the marginal private benefit (MPB) and is typically downward-sloping. In the presence of negative externalities, we introduce a social supply curve (S') that lies above the private supply curve, accounting for the additional external costs.
The market equilibrium occurs at the intersection of the private supply curve (S) and the demand curve (D), resulting in a quantity Q1 and price P1. However, this equilibrium fails to account for the full social cost. The socially optimal equilibrium occurs at the intersection of the social supply curve (S') and the demand curve (D), resulting in a lower quantity Q2 and a higher price P2.
The difference between the market equilibrium (Q1) and the socially optimal equilibrium (Q2) represents overproduction due to negative externalities. This overproduction leads to a concept known as deadweight loss, which is a measure of the economic inefficiency caused by the externality.
Deadweight loss can be visualized on the graph as the area between the social supply curve (S') and the demand curve (D), bounded by the market equilibrium quantity (Q1) and the socially optimal quantity (Q2). This area represents the net loss to society resulting from the overproduction of goods or services that generate negative externalities.
The presence of deadweight loss indicates that the market is not allocating resources efficiently. In the case of negative externalities, too many resources are being devoted to the production of goods or services that impose costs on third parties. This inefficiency arises because the market price does not reflect the true social cost of production or consumption.
To address the issue of negative externalities and reduce deadweight loss, policymakers often implement various interventions. These may include imposing taxes on producers to internalize the external costs, implementing regulations to limit harmful activities, or creating market-based solutions such as tradable permits. The goal of these interventions is to align private incentives with social costs, thereby moving the market towards a more efficient outcome.
Understanding the effects of negative externalities on market equilibrium is essential for developing effective policies and making informed decisions. By recognizing the divergence between private and social costs, we can better assess the true impact of economic activities on society as a whole. This knowledge enables us to design targeted interventions that promote economic efficiency, environmental sustainability, and social welfare.
In conclusion, negative externalities significantly impact market equilibrium by causing a divergence between private and social costs. Graphing these externalities using supply and demand curves helps visualize the overproduction and resulting deadweight loss. By addressing negative externalities through appropriate policies and interventions, we can work towards achieving a more efficient and sustainable economic system that benefits society as a whole.
Private and Social Benefits
In the realm of economics, understanding the concepts of marginal private benefit (MPB) and marginal social benefit (MSB) is crucial for analyzing market dynamics and societal welfare. These concepts are closely tied to the phenomenon of positive externalities and play a significant role in determining market equilibrium.
Marginal private benefit refers to the additional satisfaction or utility an individual consumer gains from consuming one more unit of a good or service. This benefit is directly experienced by the consumer and is reflected in their willingness to pay for that additional unit. For example, the joy a person derives from reading a book or the improved health from eating an apple are marginal private benefits.
On the other hand, marginal social benefit encompasses not only the private benefit but also any additional benefits that accrue to society as a whole from the consumption of that extra unit. This is where the concept of positive externalities comes into play. Positive externalities are benefits that extend beyond the individual consumer to affect others in society positively.
To illustrate, consider education. When an individual pursues higher education, they gain personal benefits such as increased knowledge and potential for higher earnings (marginal private benefit). However, society also benefits from having a more educated workforce, which can lead to technological advancements, economic growth, and social stability. These additional benefits to society constitute the positive externalities, and when combined with the private benefit, they form the marginal social benefit.
Graphically, these concepts can be represented on a supply and demand diagram. The demand curve typically represents the marginal private benefit, as it shows consumers' willingness to pay for each additional unit. In the presence of positive externalities, the marginal social benefit curve lies above the marginal private benefit curve. The vertical distance between these two curves at any given quantity represents the value of the positive externality to society.
The impact of these concepts on market equilibrium is significant. In a free market, equilibrium occurs where the marginal private benefit (demand) equals the marginal private cost (supply). However, this equilibrium does not account for the additional social benefits. As a result, the market tends to underproduce goods or services that generate positive externalities.
From a societal perspective, the optimal level of production occurs where the marginal social benefit equals the marginal social cost. This point typically lies to the right of the market equilibrium, indicating that a higher quantity should be produced to maximize social welfare. The difference between the market equilibrium and the socially optimal quantity represents the market failure caused by the presence of positive externalities.
Understanding these concepts is crucial for policymakers and economists. It provides a rationale for government intervention in markets where significant positive externalities exist. Common policy responses include subsidies to producers or consumers, public provision of goods or services, or regulations that encourage increased production or consumption of goods with positive externalities.
For instance, governments often subsidize education or provide it publicly because of the substantial positive externalities associated with an educated population. Similarly, research and development in fields like renewable energy or healthcare are often supported by public funds due to their potential to generate widespread societal benefits beyond what private companies might consider in their decision-making processes.
It's important to note that while the concepts of marginal private benefit and marginal social benefit are powerful tools for economic analysis, quantifying the exact value of positive externalities can be challenging. Many social benefits are intangible or difficult to measure precisely, which can complicate policy decisions aimed at correcting market failures.
In conclusion, the concepts of marginal private benefit and marginal social benefit, along with their relationship to positive externalities, provide a framework for understanding how individual actions can have broader societal impacts. By recognizing the gap between private and social benefits, economists and policymakers can work towards creating more efficient and equitable markets that better reflect the true value of goods and services to society as a whole.
Effects of Positive Externalities
Positive externalities are a crucial concept in economics that significantly impact market outcomes. These externalities occur when the production or consumption of a good or service benefits third parties who are not directly involved in the transaction. Understanding the effects of positive externalities is essential for policymakers, businesses, and consumers alike.
One of the primary consequences of positive externalities is underproduction. This occurs because the market fails to account for the full social benefits of the good or service. When producers and consumers make decisions based solely on their private costs and benefits, they overlook the additional value created for society. As a result, the market produces less than what would be socially optimal.
To illustrate this concept, consider a graph with quantity on the x-axis and price on the y-axis. The private supply curve represents the marginal costs to producers, while the private demand curve shows the marginal benefits to consumers. In a typical market, market equilibrium and externalities occur where these curves intersect. However, with positive externalities, there's an additional social benefit curve that lies above the private demand curve. This social benefit curve represents the total benefits to society, including both private and external benefits.
The difference between the private and social optimal output levels leads to deadweight loss from underproduction. This represents the potential gains to society that are not realized due to underproduction. On our graph, the deadweight loss from underproduction appears as a triangular area between the social benefit curve and the supply curve, to the right of the market equilibrium point.
Examples of positive externalities abound in various sectors. Education, for instance, not only benefits the individual receiving it but also contributes to a more productive workforce and informed citizenry. Research and development in technology often lead to spillover effects, benefiting industries beyond the original innovators. Public health initiatives, such as vaccination programs, protect not only those vaccinated but also contribute to herd immunity, benefiting the entire community.
The presence of positive externalities challenges the traditional notion that free markets always lead to efficient outcomes. In these cases, the invisible hand of the market fails to allocate resources optimally from a societal perspective. This market failure provides a rationale for government intervention to correct the underproduction and capture the full social benefits.
Policy solutions to address positive externalities often involve incentivizing increased production or consumption of the good or service in question. Subsidies are a common tool, effectively lowering the cost for producers or consumers and encouraging higher output levels. For example, governments might subsidize higher education or offer tax credits for research and development activities.
Another approach is direct government provision of goods or services with significant positive externalities. Public education systems and government-funded research programs are examples of this strategy. By taking on the production or funding of these activities, governments aim to ensure that the socially optimal level of output is achieved.
It's important to note that while addressing positive externalities can lead to more efficient outcomes, implementing corrective measures is not without challenges. Accurately measuring the full extent of external benefits can be difficult, and there's always the risk of government failure in attempting to correct market failures. Policymakers must carefully weigh the costs and benefits of intervention.
Understanding positive externalities is crucial for developing effective economic policies. By recognizing the gap between private and social benefits, we can work towards creating mechanisms that align individual incentives with broader societal goals. This not only leads to more efficient resource allocation but also contributes to overall social welfare and economic growth.
In conclusion, positive externalities significantly impact market outcomes by leading to underproduction and deadweight loss from underproduction. The discrepancy between private and social optimal output levels highlights the need for careful consideration in policy-making. By addressing these externalities through various means, societies can strive to capture the full benefits of goods and services that provide value beyond their immediate consumers or producers. As we continue to face complex economic challenges, the study and management of positive externalities will remain a critical area for economists, policymakers, and society at large.
Conclusion: The Importance of Understanding Externalities
Externalities, both positive and negative, play a crucial role in economic decision-making and market outcomes. As we've explored in the introduction video, these spillover effects can significantly impact individuals, businesses, and society as a whole. Understanding the types of externalities - production, consumption, positive, and negative - is essential for grasping their far-reaching consequences. The video has provided a solid foundation for comprehending how externalities can lead to market failures and inefficient resource allocation. By internalizing this knowledge, you'll be better equipped to analyze real-world economic situations and propose effective solutions. Whether it's addressing environmental pollution, promoting education, or evaluating public policies, the concepts of externalities are invaluable. As you move forward, apply this understanding to various scenarios, considering how different actions might generate unintended consequences or benefits for third parties. This awareness will enhance your ability to make informed decisions and contribute to more efficient and equitable economic outcomes in your personal and professional life.
Externalities Overview
Externalities Overview Externality Definition & Types
- Definition of Externality
- Positive & Negative Externality
- Positive & Negative Production Externalities
- Positive & Negative Consumption Externalities
Step 1: Definition of Externality
Externalities are defined as costs or benefits arising from production or consumption that affect the well-being of third parties who are not directly involved in the economic transaction. These effects can be either positive or negative, and the third party is not compensated for the impact. For example, if someone builds a fence to keep dogs out of their yard, it might also benefit a neighbor by keeping dogs out of their yard as well, without the neighbor compensating the fence builder. Conversely, if someone smokes a cigarette, the smoke can negatively affect the health of nearby individuals who are not compensated for this harm.
Step 2: Positive & Negative Externality
Externalities can be categorized into positive and negative externalities. Positive externalities provide benefits to third parties, while negative externalities impose costs. For instance, a positive externality might occur when a person maintains an attractive house, which can increase the market value of neighboring properties. On the other hand, a negative externality might occur when a factory pollutes the air, harming the health of nearby residents.
Step 3: Positive & Negative Production Externalities
Production externalities occur during the production process and can be either positive or negative. A negative production externality example is deforestation, which destroys wildlife habitats and increases carbon dioxide levels in the atmosphere. This activity imposes environmental costs on society. A positive production externality example is beekeeping, where bees kept for honey production also pollinate surrounding crops, benefiting the agricultural ecosystem.
Step 4: Positive & Negative Consumption Externalities
Consumption externalities arise from the consumption of goods or services and can also be positive or negative. A negative consumption externality example is smoking, which pollutes the air and poses health risks to others. A positive consumption externality example is maintaining an attractive house, which can enhance the aesthetic appeal of a neighborhood and increase property values.
FAQs
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What are the main types of externalities?
The main types of externalities are:
- Negative production externalities (e.g., pollution from factories)
- Positive production externalities (e.g., research and development spillovers)
- Negative consumption externalities (e.g., secondhand smoke)
- Positive consumption externalities (e.g., education benefits to society)
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How do externalities affect market equilibrium?
Externalities cause a divergence between private and social costs or benefits. This leads to market inefficiency, where the equilibrium quantity differs from the socially optimal quantity. Negative externalities result in overproduction, while positive externalities lead to underproduction relative to the socially optimal level.
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What is the difference between private cost and social cost?
Private cost is the direct cost incurred by a producer or consumer in an economic activity. Social cost includes both the private cost and any external costs imposed on third parties. The difference between social and private costs represents the external cost or benefit of an activity.
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How can governments address negative externalities?
Governments can address negative externalities through various methods, including:
- Imposing taxes (e.g., carbon taxes)
- Implementing regulations (e.g., emission standards)
- Creating cap-and-trade systems
- Assigning property rights (Coase theorem)
- Providing subsidies for alternatives
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Why is understanding externalities important for economic policy?
Understanding externalities is crucial for developing effective economic policies because it helps identify market failures and inefficiencies. This knowledge allows policymakers to design interventions that align private incentives with social welfare, leading to more efficient resource allocation and improved overall societal outcomes.
Prerequisite Topics for Understanding Externalities
Before delving into the complex world of externalities, it's crucial to grasp several foundational concepts in microeconomics. Understanding these prerequisite topics will provide you with a solid framework to analyze and comprehend the intricacies of externalities and their impact on markets and society.
One of the key concepts to master is deadweight loss. This economic principle is essential when examining externalities, as it helps quantify the inefficiency caused by market failures. In the context of externalities, deadweight loss often manifests as the cost to society that isn't accounted for in market transactions. For instance, when considering negative externalities like pollution, the deadweight loss from underproduction of cleaner alternatives becomes apparent.
Another critical prerequisite is understanding market equilibrium. This concept forms the baseline for analyzing how externalities disrupt the efficient allocation of resources. When studying externalities, you'll frequently encounter scenarios where market equilibrium and externalities interact, leading to suboptimal outcomes. Grasping how markets naturally tend towards equilibrium will help you appreciate the distortions caused by external costs or benefits not reflected in market prices.
Lastly, familiarity with public goods is invaluable when exploring externalities. Many solutions to externality problems involve some form of public intervention or the public provision of goods. Understanding the characteristics of public goods and why markets often fail to provide them efficiently will give you insight into why externalities occur and how they might be addressed through policy measures.
By mastering these prerequisite topics, you'll be well-equipped to tackle the complexities of externalities. You'll be able to analyze how external costs or benefits affect market outcomes, evaluate the efficiency losses they cause, and consider potential solutions through both market mechanisms and public policy interventions. Remember, externalities are a prime example of market failure, and your understanding of these foundational concepts will be crucial in developing a comprehensive view of how economies function in the real world, where perfect markets are rare.
As you progress in your study of externalities, you'll find yourself constantly drawing upon these prerequisite concepts. They will serve as valuable tools in your economic toolkit, enabling you to dissect complex scenarios, predict outcomes, and propose informed solutions to externality-related problems. Whether you're examining environmental policies, public health initiatives, or technological spillovers, your grounding in deadweight loss, market equilibrium, and public goods will prove indispensable.
Externality: A cost or benefit from a production that affects the well-being of another person, but is not compensating or being compensated for what the production did.
Within externalities, there is
- Negative externality: this creates a cost
- Positive externality: this creates a benefit
Externalities are also known as spill overs onto third parties.
There are four types of externalities
- Negative Production Externalities: Clearing forests destroys habitat of wildlife and adds more carbon dioxide to the atmosphere.
- Positive Production Externalities: Beekeepers keeping bees for their honey. The positive externality would be the pollination from surrounding crops by the bees.
- Negative Consumption Externalities: Smoking cigarettes pollutes the air around you and imposes a health risk to others.
- Positive Consumption Externalities: Maintaining an attractive house can increase the market price for houses around your neighbourhood.
Private, External, Social Cost
Now lets investigate negative externality.
Private Cost of Production: cost incurred by the producer of a good or service .
Marginal Private Cost (MC) : Additional private cost gained from a one-unit increase in production of a good or service.
External Cost of Production : a cost that is not incurred by the producer but incurred by other people.
Marginal External Cost : Additional external cost gained from a one-unit increase in production of a good or service.
Social Cost of Production : Total cost to society resulting from productions made by individuals and firms.
Marginal Social Cost (MSC) : cost incurred by the entire society from a one-unit increase in production.
Effects of Negative Externalities
Suppose we have the demand curve and the private MC curve. The market equilibrium would be the intersection of those two curves.
However, they are externality costs not covered by the firms, and incurred by others. Taking those into account, we graph the MSC curve.
Therefore, the intersection between the MSC and Demand curve is the socially optimal output.
Note: Since Q1 > Q2, we have an overproduction, thus a deadweight loss.
Private Benefit, & Social Benefit
Now lets investigate positive externality.
Marginal Private Benefit: The demand curve which does not take external benefit into account.
Marginal Social Benefit: A curve that takes all the benefits into account.
Effects of Positive Externality
Suppose we have the demand curve (MPB) and the MSC curve. The market equilibrium would be the intersection of those two curves.
However, they are externality benefit not covered. Taking the external benefit into account, we graph the MSB curve.
Therefore, the intersection between the MSB and MSC is the socially optimal output.
Note: Since Q2>Q1, we have an underproduction, thus a deadweight loss.