EXTERNALITIES
When economic activity takes place, agents are usually concerned with maximising their own welfare. This is normally shown where:
Marginal Private Costs = Marginal Private Benefits
The benefits gained from the consumption of an extra unit of a good is the equal to the cost of producing that good
Externalities: costs or benefits that are generated or received outside of the original market. Sometimes called third party effect or spillover effects
Externalities result when the private costs or benefits differ from the social costs or benefits
NEGATIVE EXTERNALITIES
Private cost: cost to the individual or firm of an economic activity
Negative externality: the cost to a third party from an economic activity
Social cost: cost to society of an economic activity
Private costs + negative externality = social costs
Examples:
cigarette smoking imposes costs on passive smokers which puts a burden on them
and also the health service
traffic congestion raises costs for business which could be passed onto the
consumer through higher prices
air pollution affects the health of children living near a motorway
In a free market the good is under priced and over consumed. Intervention is needed to correct this market failure.
POSITIVE EXTERNALITIES
Private benefit: benefit to the individual or firm of an economic activity
Positive externality: the benefits a third party receives from an economic activity
Social benefits: benefits to society of an economic activity
Private benefits + positive externalities = social benefits
Examples
education raises the productivity of the workforce which benefits firms
health care, eg vaccinations reduces the risk of other people getting an illness
painting a house could raise the value of other houses in a street