1. Externalities & Market Failure

2. What is an externality?
This arises when a person or firm engages in an activity that influences the well-being of others and yet neither pays nor receives compensation for that effect
Factoring in externalities shows the true costs and benefits to society
Negative Externality
Positive Externality
The activity causes a negative impact on the well-being of society
The activity causes a positive impact on the well-being of society

3. Negative or Positive?

4. Externality Terms Marginal private benefit
The benefit derived by the private consumer

5. Carla’s MPB when planting one flower is her enjoyment of gardening.

6. Externality Terms Marginal private benefit Marginal private cost
The benefit derived by the private consumer
Marginal private cost
The private cost to the producers of a good associated with the good’s production

7. The MPC of Carla planting one flower could be $10 (for the seed, soil, etc.)

8. Externality Terms Marginal private benefit Marginal private cost
The benefit derived by the private consumer
Marginal private cost
The private cost to the producers of a good associated with the good’s production
Marginal social benefit
The private benefit plus any external benefits placed on society

9. The MSB of Carla planting one flower is her enjoyment of gardening AND the beautiful scent it emits that the neighbors love

10. Externality Terms Marginal private benefit Marginal private cost
The benefit derived by the private consumer
Marginal private cost
The private cost to the producers of a good associated with the good’s production
Marginal social benefit
The private benefit plus any external benefits placed on society
Marginal social cost
The private cost plus any external costs placed on society

11. The MSC of Carla planting one plant is $10 AND the extra space that was taken away for the neighborhood kids to play

12. Graphing the impact of externalities

13. A market graph

14. A market graph when describing externalities

15. Lets look at the car market
Lets look at the car market. Lets assume that there are NO government regulations on car production…

16. The externalities of car production would create MARKET FAILURE!

17. Sometimes the production of the good produces a cost that is NOT included in the marginal private cost of production

18. For example, when a firm pollutes the air during production, this cost of pollution to society is NOT included in the MPC of production

19. The pollution cost is a negative externality

20. When the pollution cost is added to the MPC of production, you then get the marginal social cost to society

21. So, the marginal social cost is the TRUE cost of producing a car.

22. Let’s look at this graphically…

23. Externalities and their affects
Causes market failure
Creates deadweight loss (Total surplus not maximized)
Causes either an over-allocation or under-allocation of resources.
Producing at the socially efficient equilibrium will offset the impact of externalities. (Where demand=supply)

24. Public Policy Towards Externalities
Governments can attempt to make markets impact by externalities more efficient by doing many things:
Corrective taxes
Production regulations
Grants and subsidies
Etc…

25. Higher Education Practice
Higher education causes society to be more productive
Graph the market failure
Is it over or under allocation of resources?
Describe what the government can do to correct the market failure.