Externalities

Economics studies two forms of externalities. An externality is something that, while it does not monetarily affect the producer of a good, does influence the standard of living of society as a whole. A positive externality is something that benefits society, but in such a way that the producer cannot fully profit from the gains made. A negative externality is something that costs the producer nothing, but is costly to society in general. Examples of positive externalities are environmental clean-up and research. A cleaner environment certainly benefits society, but does not increase profits for the company responsible for it. Likewise, research and new technological developments create gains on which the company responsible for them cannot fully capitalize. Negative externalities, unfortunately, are much more common. Pollution is a very common negative externality. A company that pollutes loses no money in doing so, but society must pay heavily to take care of the problem pollution caused. The problem this creates is that companies do not fully measure the economic costs of their actions. They do not have to subtract these costs from their revenues, which means that profits inaccurately portray the company's actions as positive. This can lead to inefficiency in the allocation of resources. Because neither the market nor private individuals can be counted on to prevent this inefficiency in the economy, the government must intervene. The government's basic goal is to force companies to internalize externality costs. This means that if a company's pollution creates economic costs (for example, the medical bill of a patient who gets sick from pollution), then the government will force the company to pay that cost. In this way, the company can more accurately compare revenues and expenses and decide whether production is indeed profitable.

To achieve its goal, the government can use one of several types of regulation. It can create pollution limits, tax companies for polluting, or hand out tradable pollution permits. {Reference: http://library.thinkquest.org/26026/Economics/externality.html} Positive Externalities Definition of Positive Externality. This occurs when the consumption or production of a good causes a benefit to a third party. For example, when you consume education you get a private benefit. But there are also benefits to the rest of society. E.g you are able to educate other people and therefore they benefit as a result of your education. A farmer who grows apple trees, provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. Therefore with positive externalities the benefit to society is greater than your personal benefit. Therefore with a positive externality the Social Benefit > Private Benefit

Remember Social Benefit = private benefit + external benefit.

Diagram of Positive Externality

In a free market consumption will be at Q1 because Demand = Supply (private benefit = private cost )

However this is socially inefficient because Social Cost < Social Benefit. Therefore there is under consumption of the positive externality

Social Efficiency would occur at Q2 where Social Cost = Social Benefit For example In the real world without govt intervention there would be too little education and public transport.

Negative Externalities

Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party.

For Example, if you play loud music at night your neighbour may not be able to sleep. If you produce chemicals, but cause pollution, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.

Therefore with a negative externality Social Cost > Private Cost Diagram of Negative Externality with Deadweight welfare loss

In a free Market people ignore the external costs to others therefore output will be at Q1 (where Demand = Supply).

This is socially inefficient because at Q1 Social Cost > Social Benefit. Social Efficiency occurs at Q2 where Social Cost = Social Benefit The red triangle is the area of dead weight welfare loss. It indicates the area of overconsumption (where MSC is greater than MPC)

{Reference: http://www.economicshelp.org/marketfailure/negative-externality.html}