Q&A: Externalities and External Costs and Benefits

Could you please explain the meaning of externalities in relation to marginal social cost, marginal social benefit?

Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid. Externalities occur outside of the market i.e. they affect people not directly involved in the production and/or consumption of a good or service. They are also known as spill-over effects.

Negative externalities

Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market. When negative production externalities exist, social costs exceed private cost. This leads to an over-production of the product if producers do not take into account the externalities.

Marginal social cost = marginal private cost + marginal external cost

From a social welfare viewpoint, we want less output from activities that create an “economic-bad” such as pollution and other types of environmental damage.

There is a revision presentation on negative externalities here

Positive externalities

Positive externalities are the external benefits from production and/or consumption

Marginal social benefit – marginal private benefit + marginal external benefit

Where positive externalities exist, the good or service may be under consumed or under provided since the free market may fail to value them correctly or take them into account when pricing the product.

There is a revision presentation on positive externalities here

Here is a link to our revision notes on market failure