Externalities are a concept in economics that refer to the impact that the actions of one person or group have on the well-being of others, without that impact being reflected in market prices. This guide will cover the basics of externalities, including different types of externalities and their effects, as well as some of the policy tools that can be used to address them.
Externalities occur when the actions of one person or group affect the welfare of others in a way that is not reflected in market prices. These effects can be positive (known as “positive externalities”) or negative (known as “negative externalities”).
For example, if a company creates a new park in a city, it may have a positive externality on nearby businesses by attracting more people to the area. On the other hand, if a factory emits pollution that harms the health of nearby residents, it may have a negative externality on those residents.
There are two main types of externalities: positive and negative.
Positive externalities occur when an action taken by one person or group benefits others, without those others paying for or otherwise compensating for the benefit. Goods that exhibit a positive externality are called Merit Goods. Some examples of positive externalities include:
Negative externalities occur when an action taken by one person or group harms others, without those others being compensated for the harm. Goods that exhibit a negative externality are called Demerit Goods.Some examples of negative externalities include:
Production externalities refer to the impact of the production process on third parties who are not involved in the production of the goods or services. For example, a factory that emits pollutants into the air or water may cause health problems or environmental damage to nearby residents or wildlife. The costs of these negative externalities are not reflected in the price of the goods or services produced, and are thus not borne by the producers.
Positive: When a company builds a new factory, it creates jobs and stimulates the local economy.
Negative: When a factory emits pollution that harms the environment or people’s health, it imposes costs on society that are not reflected in the market price of the goods.
Consumption externalities, on the other hand, refer to the impact of consuming goods or services on third parties who are not involved in the consumption process.
Positive: When someone installs solar panels on their home, they reduce their carbon footprint and contribute to a cleaner environment for everyone.
Negative: When someone smokes in a public place, they expose others to second-hand smoke and increase the risk of health problems.
Externalities can have a variety of effects on different groups of people. Some of the effects include:
There are several policy tools that can be used to address externalities:
Taxes and subsidies can be used to internalize externalities. A tax can be imposed on activities that create negative externalities, such as pollution, to make the cost of those activities more accurately reflect their social cost. A subsidy can be given to activities that create positive externalities, such as education, to encourage more of those activities.
Regulation can be used to require companies to take actions to reduce negative externalities. For example, regulations can require companies to install pollution control equipment or to use cleaner technologies.
Marginal Private Benefit refers to the additional benefit that an individual or company receives from consuming or producing one more unit of a good or service. It only takes into account the benefit to the individual or company and ignores any external benefits or costs that may affect society.
Marginal Social Benefit refers to the additional benefit that society as a whole receives from consuming or producing one more unit of a good or service. It takes into account both the private benefits to individuals or companies, as well as any external benefits that affect society.
Marginal Private Cost refers to the additional cost that an individual or company incurs from producing one more unit of a good or service. It only takes into account the cost to the individual or company and ignores any external costs that may affect society.
Marginal Social Cost refers to the additional cost that society as a whole incurs from producing one more unit of a good or service. It takes into account both the private costs to individuals or companies, as well as any external costs that affect society.
When the marginal social benefit (MSB) equals the marginal social cost (MSC) of production. Kind of like equilibrium but for social rather than private cost and benefit
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