Learning Objectives

• Explain and give examples of positive and negative externalities
• Identify equilibrium price and quantity
• Evaluate how firms can contribute to market failure

Externalities

Private markets, such as the cell phone industry, offer an efficient way to put buyers and sellers together and determine what goods are produced, how they are produced, and who gets them. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. But what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller?

As an example, consider a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighborhood. You will be able to hear these outdoor concerts while sitting on your back porch—or perhaps even in your dining room. In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction. The effect of a market exchange on a third party who is outside or external to the exchange is called an externality. Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spillovers.

Externalities may be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality. If you love country music, then what amounts to a series of free concerts would be a positive externality.

Under perfect competition, the marginal cost of producing the good is not just the cost for the firm, but more broadly, it is the social cost of producing that good. When perfectly competitive firms follow the rule that profits are maximized by producing at the quantity where price is equal to marginal cost, they are thus ensuring that the additional social benefits received from producing a good are in line with the additional social costs of production. Thus, whenever the additional, or marginal, private cost of producing a good is not the same as the additional, or marginal, social cost of producing a good, the result may be inefficient, as the additional costs will be less than the additional benefits at that output level. This divergence between additional costs, or additional benefits, is an externality. The difference between private marginal costs and social marginal costs is the marginal external cost. In other words, there is a cost being imposed that is not being compensated for. The difference between private marginal benefits and social marginal benefits is marginal external benefit. In other words, there is a benefit being received that is not being paid for.

Pollution as a Negative Externality

Pollution is a negative externality. Economists illustrate the social costs of production with a demand and supply diagram. The social costs include the private costs of production incurred by the company and the external costs of pollution that are passed on to society. Figure 12.2 shows the demand and supply for manufacturing refrigerators. The demand curve (D) shows the quantity demanded at each price. The supply curve (S_private) shows the quantity of refrigerators supplied by all the firms at each price if they are taking only their private costs into account and they are allowed to emit pollution at zero cost. The market equilibrium (E₀), where quantity supplied and quantity demanded are equal, is at a price of $650 and a quantity of 45,000. This information is also reflected in the first three columns of Table 12.2.

Figure 12.2 Taking Social Costs into Account: A Supply Shift If the firm takes only its own costs of production into account, then its supply curve will be S_private, and the market equilibrium will occur at E₀. Accounting for additional external costs of $100 for every unit produced, the firm’s supply curve will be S_public. The new equilibrium will occur at E₁.

As a by-product of the metals, plastics, chemicals, and energy that are used in manufacturing refrigerators, some pollution is created. Let’s say that if these pollutants were emitted into the air and water, they would create costs of $100 per refrigerator produced. These costs might occur because of injuries to human health, property values, wildlife habitat, reduction of recreation possibilities, or because of other negative impacts. In a market with no anti-pollution restrictions, firms can dispose of certain wastes absolutely free. Now imagine that firms which produce refrigerators must factor in these external costs of pollution—that is, the firms have to consider not only the costs of labor and materials needed to make a refrigerator, but also the broader costs to society of injuries to health and other values caused by pollution. If the firm is required to pay $100 for the additional external costs of pollution each time it produces a refrigerator, production becomes more costly and the entire supply curve shifts up by $100.

As illustrated in the fourth column of Table 12.2 and in Figure 12.2, the firm will need to receive a price of $700 per refrigerator and produce a quantity of 40,000—and the firm’s new supply curve will be S_public. The new equilibrium will occur at E₁, taking the additional external costs of pollution into account results in a higher price, a lower quantity of production, and a lower quantity of pollution. The following Work It Out feature will walk you through an example, this time with musical accompaniment.

Remember that the supply curve is based on choices about production that firms make while looking at their marginal costs, while the demand curve is based on the benefits that individuals perceive while maximizing utility. If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole. Thus, if no externalities existed, the interaction of demand and supply will coordinate social costs and benefits.

However, when the externality of pollution exists, the supply curve no longer represents all social costs. Because externalities represent a case where markets no longer consider all social costs, but only some of them, economists commonly refer to externalities as an example of market failure. When there is market failure, the private market fails to achieve efficient output, because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained, a positive externality. In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product.

We can see a general lesson here. If firms were required to pay the social costs of pollution, they would create less pollution but produce less of the product and charge a higher price. In the next module, we will explore how governments require firms to take the social costs of pollution into account.

Whenever there exists positive or negative externalities, the market has not achieved the efficient or optimal result, and it has failed. Thus, one can argue that there is a role for government to remedy market failure. For both negative and positive externalities, these remedies fall into two broad categories. The first is the command-and-control approach, where the government legislates or mandates behavior. The second is the market-oriented or market-based approach, where the government attempts to incentivize choices, through taxes, subsidies, or the profit motive, which lead to internalization of the externality, and an efficient outcome.