Managerial Economics

Externalities

KING'S, MBA - 2015

Definition
In the course of producing and consuming
some commodities, harmful or beneficial
side effects arise that are borne by firms
and people not directly involved in the
production or consumption of the
commodities
These side effects are called externalities
KING'S, MBA - 2015

contd..
An externality refers to the uncompensated
impact of one persons actions on the well-being
of a bystander
Externalities cause markets to be inefficient, and
thus fail to maximize total surplus
An externality arises...

when a person engages in an activity that

influences the well-being of a bystander
and yet neither pays nor receives any
compensation for that effect.
KING'S, MBA - 2015

Contd..
When the impact on the bystander is
adverse, the externality is called a
negative externality (Also called External
Diseconomies)
When the impact on the bystander is
beneficial, the externality is called a
positive externality (Also called External
Economies)
KING'S, MBA - 2015

Contd..
Negative Externalities in Production
Air pollution by the factories through
emitting smoke
Waste of industries/factories poured into
streams or ocean create health hazard to
those people who live in surrounding areas

Positive Externalities in Production

Construction of a bridge or a highway which
reduces transportation costs and increases
the land value in neighboring area.
KING'S, MBA - 2015

Contd..
Negative Externalities in Consumption
A loud music played by your neighbor may
disturb you and cause a lot of dissatisfaction
Barking dog also create a negative externality
because neighbors are disturbed by the noise

Positive Externalities in Consumption

If a person maintains a beautiful garden,
he/she not only increases his/her own
satisfaction but also his/her neighbor enjoys
the look of his/her garden.
KING'S, MBA - 2015

Contd..

In negative externality
Social cost = private cost + external cost
Here external cost = cost to those people or
firms affected by externalities
Cost is denoted by supply curve
KING'S, MBA - 2015

Contd..
In positive externality
Social value = private value + external value
Here external value = value to those people or
firms affected by externalities
Value is denoted by Demand curve

KING'S, MBA - 2015

The Market for Commodity

Price of A
Supply
(private cost)

Equilibrium

Demand
(private value)
0

QMARKET
KING'S, MBA - 2015

Quantity of A
9

Contd..
In the presence of negative externality, the social
cost of the good exceeds the pvt costs.
The optimal quantity, Qoptimum, is therefore smaller
than the equilibrium quantity.
In other words, Negative externalities lead
markets to produce a larger quantity than is
socially desirable.
KING'S, MBA - 2015

10

Negative Externality and the Social Optimum

Price of A

Social
cost
Cost of
-ve externality

Supply
(private cost)

Optimum
Equilibrium

Demand
(private value)
0

QOPTIMUM
KING'S, MBA - 2015

QMARKET

Quantity of A

11

Contd..
The intersection of the demand curve
and the social-cost curve determines the
optimal output level.
The socially optimal output level is less
than the market equilibrium quantity.

How to reduce equilibrium quantity?

The government can internalize an
externality by imposing a tax to producer to
reduce the equilibrium quantity to the
socially desirable quantity.
KING'S, MBA - 2015

12

Contd..
In the presence of positive externality, the social
value of the good exceeds the pvt value.
The optimal quantity, Qoptimum, is therefore larger
than the equilibrium quantity
In other words, Positive externalities lead markets
to produce a smaller quantity than is socially
desirable.

KING'S, MBA - 2015

13

Positive Externality and the Social Optimum

Price of A
Supply
(private cost)

Social
value

Demand
(private value)
0

QMARKET

QOPTIMUM

KING'S, MBA - 2015

Quantity of A
14

Contd..
The intersection of the supply curve and
the social-value curve determines the
optimal output level.
The optimal output level is more than the
equilibrium quantity.
The market produces a smaller quantity
than is socially desirable.
The social value of the good exceeds the
private value of the good.
KING'S, MBA - 2015

15

Contd..
How to increase equilibrium quantity?
The government can internalize an
externality by providing subsidies to the
producer to increase the equilibrium
quantity to the socially desirable quantity.

KING'S, MBA - 2015

16

Contd..
Government action is not always
needed to solve the problem of
externalities
Private and Charitable Organizations
can also solve the problem of
externalities.

KING'S, MBA - 2015

17

Summary
When a transaction between a buyer
and a seller directly affects a third
party, the effect is called an externality
Negative externalities cause the
socially optimal quantity in a market to
be less than the equilibrium quantity
Positive externalities cause the socially
optimal quantity in a market to be
greater than the equilibrium quantity
KING'S, MBA - 2015

18

Contd
Those affected by externalities can
sometimes solve the problem privately
When private parties cannot adequately
deal with externalities, then the
government steps in

KING'S, MBA - 2015

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