1) Meaning: what is an externality?
An externality occurs when the action of a producer or consumer affects the welfare of others without compensation/payment, and this effect is not reflected in market prices.
Because external costs/benefits are not included in private decision-making, market outcomes can be inefficient.
2) Types of externalities
2.1 Negative externality
Creates external cost to others. Examples:
- pollution from factories,
- traffic congestion,
- second-hand smoke,
- noise pollution.
2.2 Positive externality
Creates external benefit to others. Examples:
- education (social benefits),
- vaccination (herd immunity),
- R&D spillovers.
3) Private vs social costs/benefits (core framework)
3.1 Negative externality
- Marginal Private Cost (MPC): cost borne by producer.
- Marginal External Cost (MEC): cost imposed on others.
- Marginal Social Cost (MSC):
3.2 Positive externality
- Marginal Private Benefit (MPB): benefit to consumer.
- Marginal External Benefit (MEB): benefit to others.
- Marginal Social Benefit (MSB):
4) Efficiency outcomes
4.1 Negative externality → overproduction
Market equilibrium typically sets:
But social optimum requires:
Since , market produces too much output (Q_market > Q_social).