Table of contents

Prepare for your exams

Upload your syllabus and get recommendations on what to study and when. No syllabus? Sharing your exam schedule works too.

Skip topic navigation

1. Introduction to Macroeconomics1h 57m
2. Introductory Economic Models59m
3. Supply and Demand3h 43m
4. Elasticity2h 26m
5. Consumer and Producer Surplus; Price Ceilings and Price Floors3h 40m
6. Introduction to Taxes1h 25m
7. Externalities1h 3m
8. The Types of Goods1h 13m
9. International Trade1h 16m
10. Introducing Economic Concepts49m
11. Gross Domestic Product (GDP) and Consumer Price Index (CPI)1h 37m
12. Unemployment and Inflation1h 15m
13. Productivity and Economic Growth1h 17m
14. The Financial System1h 37m
15. Income and Consumption52m
16. Deriving the Aggregate Expenditures Model1h 22m
17. Aggregate Demand and Aggregate Supply Analysis1h 18m
18. The Monetary System1h 1m
19. Monetary Policy1h 32m
20. Fiscal Policy1h 0m
21. Revisiting Inflation, Unemployment, and Policy46m
22. Balance of Payments30m
23. Exchange Rates1h 16m
24. Macroeconomic Schools of Thought40m
25. Dynamic AD/AS Model35m
26. Special Topics11m

7. Externalities

Externalities: Social Benefits and Social Costs

7. Externalities

Externalities: Social Benefits and Social Costs: Videos & Practice Problems

Video Lessons Practice Worksheet

Topic summary

Externalities are costs or benefits imposed on innocent bystanders not involved in a transaction. Negative externalities, like pollution from a factory, lead to overproduction as they ignore social costs, while positive externalities, such as education, result in underproduction by not accounting for societal benefits. The marginal social cost (MSC) and marginal social benefit (MSB) curves illustrate these concepts, highlighting market inefficiencies and deadweight loss. Property rights play a crucial role in addressing externalities, as unclear rights can lead to market failures.

concept

Negative Externality and Positive Externality

Video duration:

10m

Play a video:

Was this helpful?

Negative Externality and Positive Externality Video Summary

Externalities are important concepts in economics that extend the idea of costs and benefits beyond just the buyer and seller in a transaction to include the entire society. They can be classified into two main types: negative externalities and positive externalities. Understanding these concepts helps us recognize how individual actions can impact innocent bystanders who are not directly involved in a transaction.

A negative externality occurs when a transaction imposes a cost on third parties. For instance, consider a paper production factory that discharges pollutants into a nearby lake. The private costs for the factory include expenses related to cutting down trees and processing them into paper. However, the pollution affects local residents, imposing an external cost on them. This leads to the concept of social cost, which combines the private cost with the external cost, represented by the Marginal Social Cost (MSC) curve. The MSC reflects the true cost of production, including the negative impacts on society.

Another example of a negative externality is owning a loud dog. While the owner incurs private costs such as food and care, the barking may disturb neighbors, creating an external cost that affects their well-being. This highlights how individual decisions can have broader societal implications.

Conversely, positive externalities create benefits for third parties. For example, vaccinations provide a private benefit to the individual receiving the vaccine by protecting them from illness. However, they also benefit society by reducing the spread of contagious diseases, leading to a healthier population. This external benefit is captured in the Marginal Social Benefit (MSB) curve, which includes both the private benefit and the additional societal benefits.

Education serves as another example of a positive externality. While individuals pursue education for personal gain, such as higher salaries, a more educated population enhances overall productivity, benefiting society as a whole. The external benefits of education contribute to a more efficient and productive workforce.

It is important to note that external costs and benefits can be challenging to quantify. For instance, measuring the impact of pollution on residents' happiness or the societal benefits of a less contagious population involves intangible factors. Despite these challenges, understanding externalities is crucial for recognizing the broader implications of economic transactions and for developing policies that address these societal impacts.

concept

Externalities on the Graph

Video duration:

14m

Play a video:

Was this helpful?

Externalities on the Graph Video Summary

Externalities are significant economic concepts that can lead to market failures, impacting both production and consumption. A negative externality occurs when a company's actions impose costs on others without compensation. For instance, consider a paper production company that discharges pollutants into a lake, affecting the quality of life for nearby residents. In this scenario, the supply curve (S1) reflects the private costs of production, such as raw materials and labor, but does not account for the external costs of pollution. This results in an equilibrium quantity (QM) that is higher than the socially optimal quantity (Q*), leading to overproduction and a deadweight loss due to inefficiencies in the market.

Conversely, positive externalities arise when a product or service provides benefits to others not directly involved in the transaction. An example is education, which not only benefits the individual receiving it but also enhances societal productivity. In this case, the demand curve (D1) reflects only the private benefits of education. When considering the additional societal benefits, the demand curve shifts to the right (D2), indicating an increase in overall demand. This shift results in an equilibrium quantity (Q*) that is higher than the market quantity (QM), leading to underproduction of education and a corresponding deadweight loss.

Both types of externalities highlight the importance of considering all costs and benefits in economic decision-making. When externalities are present, markets fail to reach efficient outcomes, resulting in either overproduction or underproduction. The existence of externalities often stems from poorly defined or unenforced property rights. For example, if the paper company owns the lake, it can pollute without consequence. However, if the residents own the lake, they can negotiate compensation for pollution, internalizing the external costs and moving towards a more efficient market outcome.

In summary, understanding externalities is crucial for recognizing how they disrupt market efficiency. Addressing these issues often requires intervention, such as government regulation or the establishment of clear property rights, to ensure that all costs and benefits are accounted for in economic transactions.

Problem

If the production of a good causes a negative externality, then the social-cost curve will lie the supply curve, and the socially optimal quantity is _ than the equilibrium quantity.

Above; Greater

Above; Less

Below; Greater

Below; Less

Do you want more practice?

We have more practice problems on Externalities: Social Benefits and Social Costs

Here’s what students ask on this topic:

What are externalities in economics?

Externalities are costs or benefits that affect third parties who are not directly involved in a transaction. They can be either negative or positive. Negative externalities, such as pollution from a factory, impose additional costs on society that are not reflected in the market price. Positive externalities, like education, provide additional benefits to society that are not captured by the market. These externalities lead to market inefficiencies, as the true social costs or benefits are not accounted for in the market equilibrium.

How do negative externalities lead to overproduction?

Negative externalities lead to overproduction because the market price does not reflect the true social cost of production. For example, a factory that pollutes a lake imposes additional costs on nearby residents. These costs are not included in the factory's production costs, leading to a lower market price and higher quantity produced than is socially optimal. The marginal social cost (MSC) curve, which includes both private and external costs, lies above the private cost curve, indicating that the true cost of production is higher than what the market reflects.

What is the difference between private cost and social cost?

Private cost refers to the costs incurred by the producer or seller in the production of goods or services. These costs are typically represented by the supply curve in a market. Social cost, on the other hand, includes both the private cost and any external costs imposed on society. For example, in the case of a factory that pollutes, the social cost would include the private cost of production plus the cost of pollution borne by the community. The social cost is represented by the marginal social cost (MSC) curve, which lies above the private cost curve.

How do positive externalities result in underproduction?

Positive externalities result in underproduction because the market price does not capture the full social benefits of the good or service. For instance, education provides private benefits to the individual, such as higher earnings, but also external benefits to society, such as increased productivity and lower crime rates. These external benefits are not reflected in the market demand, leading to a lower quantity produced than is socially optimal. The marginal social benefit (MSB) curve, which includes both private and external benefits, lies above the private benefit curve, indicating that the true benefit to society is higher than what the market reflects.

What role do property rights play in addressing externalities?

Property rights are crucial in addressing externalities because they help define who has control over resources and who bears the costs or benefits of externalities. When property rights are clearly defined and enforceable, parties can negotiate to internalize externalities. For example, if residents own a lake, they can negotiate with a polluting factory to compensate for the pollution. This internalizes the external cost, leading to a more efficient market outcome. However, when property rights are unclear or difficult to enforce, externalities are more likely to persist, leading to market failures.