What Are Externalities?

What are externalities?

Externalities are common in virtually every area of economic activity. They are defined as third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid.

Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption.

The study of externalities by economists has become extensive in recent years - not least because of concerns about the link between the economy and the environment.

PRIVATE AND SOCIAL COSTS

Externalities create a divergence between the private and social costs of production.

Social cost includes all the costs of production of the output of a particular good or service. We include the third party (external) costs arising, for example, from pollution of the atmosphere.

SOCIAL COST = PRIVATE COST + EXTERNALITY

For example: - a chemical factory emits wastage as a by-product into nearby rivers and into the atmosphere. This creates negative externalities which impose higher social costs on other firms and consumers. e.g. clean up costs and health costs.

Another example of higher social costs comes from the problems caused by traffic congestion in towns, cities and on major roads and motor ways.

It is important to note though that the manufacture, purchase and use of private cars can also generate external benefits to society. This why cost-benefit analysis can be useful in measuring and putting some monetary value on both the social costs and benefits of production.

MARKET FAILURE AND EXTERNALITIES

When negative production externalities exist, marginal social cost > private marginal cost. This is shown in the diagram below where the marginal social cost of production exceeds the private costs faced only by the producer/supplier of the product. In our example a supplier of fertiliser to the agricultural industry creates some external costs to the environment arising from their production process.