Microeconomics
1.1.6 Externalities
The market system
What are externalities?
Externalities: the spillover effects of consumption or production.
When a firm produces something or a person consumes something, the effects do not always stop with them. Some effects spill over onto third parties: people or organisations outside the activity, who are neither producing nor consuming the good. Local residents, other businesses and passers-by are all examples.
Two types of externality:
- Negative externalities: harmful effects on third parties, also called external costs.
- Positive externalities: helpful effects on third parties, also called external benefits.
External costs of production
External costs: A negative effect imposed on a third party.
Third parties suffer the effect, but they did not cause it and the producer does not pay them for it.
Examples of external costs:
- Pollution: a factory or brick kiln releases smoke and dust that local people breathe in, harming their health. Waste chemicals dumped into rivers pollute water that other people use. Aircraft and building sites create noise pollution for people nearby.
- Congestion: lorries and vehicles linked to a business crowd the roads, so other drivers face delays. Traffic jams also cause pollution that harms the health of pedestrians.
- Environmental damage: forests are cut down for new factories, farms or housing, and rivers and coastal waters are polluted with farm waste.
Consumption can create external costs too. For example, a smoker’s cigarette smoke harms the health of people around them, and litter dropped by consumers spoils public places.
Example: a new cement factory
A cement factory opens on the edge of a town.
- Pollution: dust from the factory settles on nearby homes, and some residents develop breathing problems.
- Congestion: heavy lorries carrying cement fill the main road every morning, making local commuters late for work.
- Environmental damage: a quarry for the factory’s raw materials destroys an area of woodland.
None of these residents or commuters are involved in making or buying cement, so they are all third parties.
External benefits of consumption
External benefits: A positive effect enjoyed by a third party.
Third parties gain from the activity even though they did not pay for it.
Examples of external benefits:
- Education: the student gains a better job and higher pay. Society also gains, as well-educated people can do highly skilled jobs, e.g. as doctors or engineers. This raises productivity and the standard of living, and may lower unemployment.
- Healthcare: the patient feels better and can return to work. Healthy people also work more effectively and pay taxes, which benefits the rest of society.
- Vaccinations: the person vaccinated is protected from a disease. Others also benefit, because fewer people can catch and pass on the disease, so even people who are not vaccinated are less likely to get it.
Production can create external benefits too. For example, a new shopping centre creates jobs for local people and gives the area new shops to use.
Example: A school runs a free flu vaccination day and 900 pupils are vaccinated. Each pupil is protected from flu (the private benefit). Because far fewer pupils catch flu, their teachers, younger brothers and sisters, and grandparents are also less likely to catch it, even though they were not vaccinated (the external benefit).
Social costs and social benefits
Every economic activity has costs and benefits. Some fall on the people doing the activity, and some fall on third parties.
Private costs: costs of an economic activity to individuals and firms.
Private benefits are what the individuals and firms carrying out an activity gain from it, e.g. the revenue a firm earns or the enjoyment a consumer gets.
Social costs
Social costs: Private costs plus external costs.
Social costs are the full cost of an activity to society as a whole: the cost to the firm or individual, plus the cost to third parties.
Formula:
Social costs = Private costs + External costs
Social benefits
Social benefits: Private benefits plus external benefits.
Social benefits are the full benefit of an activity to society as a whole: the benefit to the firm or individual, plus the benefit to third parties.
Formula:
Social benefits = Private benefits + External benefits
Social costs only include costs, and social benefits only include benefits.
Example: a new airport runway
A city airport builds a new runway. The estimated yearly figures are:
- Private costs: $40 million for running and maintaining the runway, paid by the airport.
- External costs: $12 million from noise and air pollution for people living under the flight path.
- Private benefits: $65 million in landing fees and shop rents earned by the airport.
- External benefits: $20 million from new jobs and extra tourists spending money in local businesses.
Social costs = $40 million + $12 million = $52 million.
Social benefits = $65 million + $20 million = $85 million.
