Externalities occur when costs or benefits accrue to a person, or persons, who are not

involved in the decision-making process.

Note that externalities can involve either third-party costs (this would be a negative

externality) or third-party benefits (this would be a positive externality).

Let's address each of these in turn.

Negative externalities occur when a decision or activity imposes costs on anyone not involved

in making that decision.

Think of it this way: every decision involves some cost to the decision-maker; that's the

private cost of your choice.

But sometimes the decision imposes costs on others as well, which would be the external

cost.

Social cost, then, is the total cost to all members of society, or the sum of the cost

to the decision-maker (which is private cost), and to others (external cost).

What this means is that if a decision imposes any kind of external cost, then the social

cost will exceed the private cost.

Think about this: do you think that too many people use their cell phones while driving,

or too few?

Well, why do you think that is?

The answer lies with this notion of externalities.

Look at it this way: when you're deciding whether or not to get on your cell phone while

you're driving, what are the private costs, i.e. the costs to you, the decision-maker?

Perhaps the cost of buying a cell phone in the first place?

Or maybe the minutes you'll be using, or the cost of sending a message?

It might even occur to you that you're increasing the likelihood of you getting into an accident.

Now are there any costs to other people, people who have no control over your decision to

use your phone while behind the wheel?

What about the increased risks to them?

Or even just the annoyance of you driving like an idiot because you're on the phone?

These are the external costs, or the costs you impose on others with your behavior.

In the end, this discrepancy between the cost to you and the cost to society (which is the

sum of the private and the external cost) leads to overproduction, if you will, of people

driving while on their cell phones.

Why?

Because we’re all rational decision-makers -- using the cost to us and the benefits to

us to make our decisions.

Very rarely do you find someone who includes costs to others when weighing a private decision.

Essentially, you make the decision to be on the phone while driving because you consider

only part of the cost - the cost to you.

With negative externalities, because the private decision is based on costs that are too low,

from society’s standpoint, the behaviors, or products, are overproduced from society's

view.

This market failure provides a role for the government to correct the market, i.e. bring

the production back to the socially optimal level.

In the case of cell phones, this is most often done by putting laws in place that ban such

behavior while driving, and have hefty fines attached if you're caught.

This effectively raises the cost of engaging in such behavior, and thus decreases the amount

of the behavior that occurs.

The same idea would apply to, say, a steel factory.

There's a certain private cost of producing steel (I’ll assume that on the benefit or

demand-side, private and social are the same for now), but the production of steel also

results in pollution, a cost to others in society.

This means that the marginal social cost is greater than the marginal private cost.

Left to its own devices, the steel market will be based on private costs and private

benefits, yielding the price and quantity associated with equilibrium E1.

What would society rather see?

The socially optimal outcome would be based on social cost and social benefits, or equilibrium

E2.

Notice, this means society would like to see less production, meaning less pollution, and

would be willing to pay a higher price to do so.

This is where the government comes in.

What is the government solution to a negative externality?

Simple!

Get the decision-maker to internalize the external effect.

Since the problem arises from the decision-maker using costs that are too low, you need to

somehow impose some additional cost, so the decision becomes based on level of social

cost.

This could be done by way of taxes, fines, regulation or cleanup fees.

Or, in the case of pollution, there’s now a market for credits that allow you to pollute.

If you're clean producer, you’ll have unused credits you can sell which is an incentive

for cleaner production.

If you create a lot of pollution, you’ll need to acquire extra credits to continue

producing, which is also an incentive to cut back on pollution production.

What about positive externalities?

Just as you can make choices that impose costs on others, you can also make choices that

result in benefits to others.

If this is the case, then social benefits equal the private benefits, or benefits to

the decision-maker, plus external benefits, or benefits to others.

In the case of a positive externality, social benefits exceed the private benefits.

Take education, for example.

YOU decided to continue your education; why is that?

What are the benefits to you of making this decision?

It might just be the love of learning, or because you know that education means a better,

higher-paying job in the future.

But what about society?

Society as a whole benefits from having a better-educated populace; highly-educated,

highly-skilled workers tend to be innovators, which helps keep our economy moving forward.

All of this is good except for the fact that, in a free market, education will be underproduced

-- this is true of any positive externality.

Why?

Because the private decision-maker doesn't see the full benefit of education that society

sees, so not as much education is produced.

For the consumer of education, there's a certain private benefit (I’ll assume private cost

and social cost are going to be the same).

Decision-making based solely on private costs and benefits results in equilibrium at E1.

Society as a whole sees a greater benefit; if the equilibrium were based on social costs

and social benefits, equilibrium would occur at E2.

Society desires a greater level of education, and is willing to pay more to achieve it.

From a social standpoint, in a free-market, education will be underproduced.

What's the government solution to a positive externality?

Well, get the decision-maker to internalize the external effect.

Sounds familiar, doesn't it?

Except that with the negative externality, we had to try to get the decision-maker to

see higher costs; with a positive externality, the government needs to somehow make the decision

more beneficial to the private decision-maker.

In the case of education, the government may provide grant money, low-interest loans, or

tax credits in order to provide added incentive to get more education.

NEXT TIME: Public goods TRANSCRIPT00(MICRO) EPISODE 32: EXTERNALITIES