In this video I’ll cover the concept of negative externalities.
By the end of this video you will be able to explain what a negative externality is
and also be able to diagram a negative externality in consumption and also in production.
So what exactly is a negative externality?
A negative externality occurs when a third-party, NOT involved in an economic transaction, is
harmed from THAT transaction.
A common example for consumption, is smoking, which I will explain further in the next few
slides.
Let’s consider the case of negative consumption externalities.
With negative consumption externalities, the social benefit equals the private benefit
minus the external cost.
I subtract external costs because we assume there are negative social benefits.
Rather than add a negative benefit, I subtract the external cost.
Let’s break down what this means.
The social benefit represents the benefit to society as a whole.
The private benefit is the benefit received by the individual consuming the good or service
and the external costs, or the externality, are the costs to a third-party not involved
in the transaction.
In the case of smoking, there is a negative externality to smoking in public places.
Smokers sometimes enjoy their cigarettes in public without thinking of those affected
who are around them.
This could be other children or adults.
This explains why, at least in the US and UK, smoking is banned in many public places
and within all public buildings.
Now let’s look at the diagram.
Costs and benefits are on the Y-axis.
Output on the X.
Our marginal private cost and marginal social cost are the same here because we assume there
are no external costs in production.
The marginal private benefit curve represents the benefit gained by the additional consumption
of a good or service.
The equilibrium price and output for this combination is P* and Q*.
The free market would provide Q* quantity at a price of P*.
If we factor in the costs imposed to individuals not involved in the transaction and subtract
them from the marginal private benefit, we arrive at our marginal social benefit.
This includes the costs to the individual and all third parties.
You’ll notice it is to the left of the original MPB curve.
The socially optimum level of output is Qs at a price of Ps.
If the market was left to operate without any intervention, the result would be that
this good would be over provided when we consider the additional costs tied to the externality.
Therefore, we say that there is a welfare loss, or deadweight loss represented by triangle
XYZ, which I will now display.
To determine the welfare loss we consider the points at which the marginal social benefit
is less than the marginal social cost, from our original equilibrium of P*Q*.
Since the marginal social benefit at that point, Y, is less than the marginal social
cost, X, less of this good should be produced.
The welfare loss represents the sum of the costs of those additional units being consumed,
beyond the socially optimal level of output where marginal social benefit equals marginal
social cost, or price Ps and quantity Qs.
The welfare loss is represented by triangle XYZ.
Having an understanding of negative consumption externalities should helps us understand negative
production externalities.
In the case of a negative production externality, the social cost of production is equal to
the marginal private cost plus the marginal external costs.
The supply curve shifts by the amount of the external cost.
Assume that a factory is producing goods that require them to emit a certain amount of air
pollution.
The private costs to the factory owners include wages to employees, cost of materials, utilities,
operating licenses and rent.
The external cost include the costs borne by third parties as result of the pollution.
That could involve pollution clean up or medical expenses in treating air pollution related
illness.
The social cost includes both the private cost of doing business and the cost to third
parties of dealing with air pollution.
The costs of production are a burden on both the producing firm and the uninvolved third
party.
Both parties have to dedicate resources to deal with the production levels of the firm
so therefore to achieve the socially optimal level —considering marginal social cost
is a necessity.
A negative production externality occurs when a third party faces a cost as a result of
the production process of another firm.
Let’s work through the diagram.
We use the same axes as before.
This time we assume that our marginal private benefit and marginal social benefit curves
are the same.
Next we add in our marginal private cost.
If left to market, the production level would be Q* at a price of P*.
However, the marginal social cost is greater than the marginal private cost due to the
costs incurred by third parties that are harmed as a result of the production process.
Thus the socially optimum level of output, Qs, is less than the free market allocation,
Q*.
The socially optimum price, Ps, is higher than the free market price, P*.
The welfare loss, or deadweight loss in this scenario is represented by the triangle XYZ.
We can see this by starting at our initial equilibrium point and noting that our marginal
social cost, Y, is higher than the marginal social benefit, X, and therefore production
should be reduced.
If we continue this reduction until marginal social benefit equals marginal social cost,
we’ll note that the free market allocation leaves us with a deadweight of triangle XYZ.
That wraps up this video on negative externalities.
By now you should be able to explain what a negative externality is and diagram both
negative consumption and production externalities.
If you have any questions or comments, leave them below or email me.
Visit the website listed below and check out the additional resources available to help
you study.
For now that’s us done and I will see you in the next one!