Section 6.3 Externalities
When we measure costs and benefits in economic transactions, we typically focus on the costs and benefits for those individuals participating in the transactions. For example, a firm chooses to sell when its marginal benefit from selling exceeds its marginal cost. We hone in on the costs and benefits from the firm’s perspective because those costs and benefits are the ones relevant to the firm’s decision making. If our objective is to study market behavior, such as identifying the quantity supplied at a market outcome, focusing exclusively on the firm’s costs is justified.
But, market transactions can often generate costs and benefits to those not participating directly in the market. A buyer who purchases a new cherry tree for his yard can generate some added benefit to his neighbors if they enjoy looking at a lovely tree. A buyer who purchases a loud stereo system can impose added costs on his neighbors if he plays loud music his neighbors do not enjoy. Added benefits or costs from market transactions are called externalities.
We use the term external-ity since it measures benefit or cost that is felt external to the transaction, and therefore, external to the costs and benefits of the relevant decision makers. When a cherry tree is sold, the buyer and seller each considers their costs and benefits, but since neither party is likely concerned about how the tree will make neighbors feel, no external benefits are part of the decision! 1
If a decision or transaction generates an added cost to those outside of the market, we call this added cost a negative externality. One common example is pollution: if, as a result of a production process, a firm emits air pollution from its factory, this is a negative externality. The air pollution imposes an added cost on all of society, who must pay in the form of a more damaged environment. Importantly, the added cost is external because the firm is likely not considering the full cost of its actions when it makes its decision - which is based on weighing its marginal revenue and marginal cost.
A consumer can also generate a negative externality from, say, driving a car (emitting air and noise pollution, for example), or from smoking a cigarette. If smoking a cigarette generates second-hand smoke, endangering the health of those around the smoker, this represents a negative externality. The individuals around the smoker incur an added cost (greater health risks) which is likely not part of the smoker’s decision making process. 2 A consumer with a loud stereo or fireworks can impose a negative externality on her neighbors. Can you think of other examples of negative externalities?
On the other hand, a positive externality is an added benefit to society which is generated by a decision or transaction. When someone gets a flu shot, the buyer weighs her costs and benefits (how much does the flu shot cost me, how badly do I not want to get the flu), and so does the seller (what is the marginal revenue and marginal cost of producing the flu shot). But anytime someone gets a flu shot, society at large receives an added benefit - the reduced chance that others in society will get the flu! The externality is not directly part of the calculation for either the buyer or seller, but is an important benefit to society. There are many examples of transactions which generate positive externalities: a student who goes to college generates a positive externality by becoming a well-informed citizen; a bakery that produces good-smelling baked goods generates a positive externality to those who smell them; a neighbor who buys fireworks might generate a positive externality to his neighbors who enjoy fireworks. 3
The study of externalities is critical in economics. Some of the most pressing economic issues society faces - climate change, urban development, traffic congestion - are the result of the unconsidered consequences of decision makers’ decisions. The full costs to the environment of carbon emissions, from factories or from automobile drivers, are felt by all of society. How, then, could a single decision maker account for such a cost in their decision making?
We are used to talking about costs and benefits from the perspective of a relevant decision maker. But in the presence of an externality, the costs and benefits to society at large become relevant. When studying markets which generate externalities, it is critical to acknowledge the difference between private costs/benefits and social costs/benefits.
Simply put, the private costs and benefits of a transaction will measure the costs and benefits which go to the decision makers themselves. In the flu shot example, then, private benefit is the benefit which goes to the individual who purchases the flu shot; the private cost is the cost to producers for manufacturing the flu shot. Private costs and benefits capture the relevant factors for decision makers.
Social costs and benefits of a transaction, on the other hand, will capture all costs and benefits generated to society. Therefore, social costs and benefits 1) include the private costs and benefits, since decision makers are part of society; and 2) also include any externalities generated. In the flu shot example, the social benefit of a flu shot purchase includes the benefit to the individual who makes the purchase (the private benefit), plus the added benefit to society from a decreased risk of spreading the flu (the externality). In the flu shot example, therefore, the social benefits exceed the private benefits, due to the presence of the positive externality! This relationship between private and social benefits/costs will generally hold true as a broad principle:
- In the presence of a positive externality, the social benefit will exceed the private benefit.
- In the presence of a negative externality, the social cost will exceed the private cost.
There seems to be a fairly intuitive overarching lesson in markets with externalities. Since markets which generate negative externalities are generating higher costs to society than the decision makers consider, we likely want to incentivize less of these activities: lower carbon emissions, less cigarette smoking, fewer cars on the road. Conversely, markets which generate positive externalities have added benefits beyond what market participants consider, giving a reason to incentivize more of these activities: plant more flowers, encourage more flu shots, support broader access to education.
But how do we determine the quantity of an activity that is realized in a market? We know this! A market or activity will trend toward an outcome where the marginal benefit of the last unit equals the marginal cost of the last unit. We will use our tried-and-true
\begin{equation*}
MB = MC
\end{equation*}
condition to guide our analysis of how much activity we get in markets with externalities. But remember! We now must distinguish between private benefits/costs and social benefits/costs. Let’s start with the private, using flu shots as our example.
Private marginal cost (PMC) is the added cost of providing one additional flu shot to the market. In a market context, this captures the sellers in the market. We know that in general, marginal cost is increasing, and under diminishing marginal product of labor, this should be true in the market for flu shots. Therefore, we should have an upward-sloping private marginal cost curve - which we have seen is the same as the market supply curve!
Private marginal benefit (PMB) is the added benefit for each additional flu shot purchased in the market. Provided the market allocates goods efficiently, the first unit purchased will go to the consumer with the highest willingness to pay, generating the highest marginal benefit to unit one. Additional flu shots add smaller and smaller benefits, giving us the typical downward-sloping private marginal benefit curve. Since PMB reflects consumers’ willingness to pay, this curve is exactly the market demand curve!
On the private side, then, we should observe a quantity of flu shots where the private marginal benefit equals the private marginal cost. This private outcome - which we will denote as \(q^*_{PRIV}\) - is the same as the market outcome, since it represents the interaction between buyers (PMB) and sellers (PMC) that leads to market equilibrium. A flu shot will be purchased if the marginal benefit to that buyer exceeds the marginal cost to that seller, and flu shots will continue to be purchased until PMB equals PMC.
PMB and PMC do not incorporate any externalities, since they are defined as measuring private (and not social) values. Therefore, the private outcome \(q^*_{PRIV}\) represents the actual amount of the activity in the market as a result of direct interactions between buyers and sellers. One way to interpret this is to ask: if all relevant decision makers consider private costs and benefits, how much of this activity/good will we get? The answer is \(q^*_{PRIV}\text{.}\)
We can use the same approach to now consider externalities. If instead, we use social marginal benefit (SMB), the added benefit to society of one additional flu shot, and social marginal cost (SMC), the added cost to society of one additional flu shot, then marginal analysis confirms that the optimal quantity should arise where
\begin{equation*}
SMB = SMC
\end{equation*}
We will call this optimal quantity \(q^*_{SOC}\text{,}\) the socially optimal outcome. Since social \(MB\) and social \(MC\) capture both decision makers and society as a whole, we can frame this socially optimal outcome differently: if activity in the market could be directed to the optimal state for society as a whole 4 , how much of the activity should we achieve? The answer is \(q^*_{SOC}\text{.}\)
As a quick recap, when we study markets which generate externalities, two quantities are of interest: \(q^*_{PRIV}\text{,}\) the market outcome that would be produced when buyers and sellers interact; and \(q^*_{SOC}\text{,}\) the socially optimal outcome that is would be best for society as a whole since it takes all benefits and costs (private and social alike) into account. If we tie this back to our intuitive hypothesis from earlier, we might state two proposals:
- Hypothesis: in a market with a positive externality, \(q^*_{SOC} > q^*_{PRIV}\text{;}\) that is, the market underprovides the activity relative to what is socially optimal.
- Hypothesis: in a market with a negative externality, \(q^*_{SOC} \lt q^*_{PRIV}\text{;}\) that is, the market overprovides the activity relative to what is socially optimal.
We will now check to see if these two hypotheses hold true in our externalities model.
Earlier, we discussed that positive externalities generated greater social benefits than private, and similarly, that negative externalities generated greater social costs than private. But with a clear focus now on marginal benefits and marginal costs, we can restate these two relationships:
- In the presence of a positive externality, the social marginal benefit curve will exceed the private marginal benefit curve.
- In the presence of a negative externality, the social marginal cost curve will exceed the private marginal cost curve.
Since a market with a positive externality generates additional benefits to society and no additional costs, \(SMB > PMB\) and \(SMC = PMC\) in this case. If we combine these curves, we can compare the market outcome \(q^*_{PRIV}\) with the socially optimal outcome \(q^*_{SOC}\text{.}\) As we can see in the graph below, our hypothesis is confirmed: in the presence of a positive externality, the socially optimal quantity exceeds the market outcome, indicating that the market will do too little of this activity (too few flu shots, too little education) relative to what is best for society. This should make sense, since decision makers fail to account for the full benefits of their actions.
We can conduct similar analysis in a market with a negative externality. Here, the additional costs incurred by society lead to \(SMC > PMC\) and \(SMB = PMB\text{.}\) When these curves combine, as we see below, we can observe that \(q^*_{SOC} \lt q^*_{PRIV}\text{,}\) again confirming our hypothesis above. The market outcome exceeds the socially optimal level of activity, demonstrating that if left to its own devices, the market will do more of this activity (more carbon emissions, more cigarettes smoked) than is in the best interest for society, precisely because the decision makers do not consider the full costs of their actions.
A snapshot of the comparison between positive and negative externalities is given here:
| Positive externality | Negative externality | |
| Examples | flu shots; education; | carbon emissions; pollution; |
| bakery smells; planting flowers | cigarette smoking | |
| Marginal benefit | \(SMB > PMB\) | \(SMB = PMB\) |
| Marginal cost | \(SMC = PMC\) | \(SMC > PMC\) |
| Level of activity | \(q^*_{SOC} > q^*_{PRIV}\text{;}\) market underprovides | \(q^*_{PRIV} > q^*_{SOC}\text{;}\) market overprovides |
| Policy recommendation | incentivize more of this?? | incentivize less of this?? |
Key terms in this section:
- externality
- positive externality
- negative externality
- private marginal benefit
- private marginal cost
- private outcome/market outcome
- social marginal benefit
- social marginal cost
- socially optimal outcome
- internalize the externality
