6.2 Externalities

What are externalities?

An externality occurs when a market transaction affects a third party not involved in the exchange. Negative externalities (e.g., pollution) impose costs on others, causing overproduction since private cost < social cost. Positive externalities (e.g., vaccinations, education) create benefits for others, causing underproduction since private benefit < social benefit relative to the social optimum.

Marginal social cost/benefit and deadweight loss

With negative externalities, marginal social cost (MSC) > marginal private cost (MPC), so the market quantity exceeds the socially optimal quantity, creating deadweight loss. With positive externalities, marginal social benefit (MSB) > marginal private benefit (MPB), so market quantity is below optimal, also creating deadweight loss. The socially optimal quantity occurs where MSB = MSC.

Government correction tools

Governments can correct externalities using taxes (on negative externalities, shifting supply left to raise price toward social cost) or subsidies (on positive externalities, shifting supply right to lower price toward social benefit). Other tools include regulation, tradable permits, and defining property rights (Coase theorem), all aiming to move output to the socially optimal level.

Key terms

Externality

A cost or benefit from a transaction that affects a third party not involved in the exchange.

Negative externality

MSC > MPC; leads to market overproduction relative to the social optimum (e.g., pollution).

Positive externality

MSB > MPB; leads to market underproduction relative to the social optimum (e.g., education, vaccines).

Socially optimal quantity

The output level where marginal social benefit equals marginal social cost (MSB = MSC).

Pigouvian tax/subsidy

A tax on negative externalities or subsidy for positive externalities designed to align private incentives with social costs/benefits.

Try an AP-style question

An externality is…

1. a tax on imports
2. a cost or benefit to third parties
3. a cost paid by the buyer
4. a firm's fixed cost