Externalities result from differences between private and social costs or benefits
Externalities can be positive or negative:
- Positive – these have beneficial effects on 3rd parties
- Negative – these are costs that incurred by 3rd parties
The presence of negative externalities is likely to cause over production of a product
The presence of positive externalities is likely to lead to under production of a product
Externalities can lead to market failure if the pricing mechanism fails to account for the social costs and benefits of production
Positive Externalities
If the business was supplying products ignoring social benefits the initial supply curve S1
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Negative Externalities
If you consider private costs then they would supply along supply curve S. Negative externalities mean that social costs are higher so the new supply curve should be S1 and equilibrium moved to P1
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Value of Externalities
The value of social costs and benefits can be measured by looking at:
- Consumer surplus
- Producer surplus
- Cost-benefit analysis : what is the balance of costs and benefits
- Willingness to pay
External Benefits - Positive Externalities
As well as external costs businesses can create external benefits. External benefits are advantages a business brings to the local community when it locates its business in a particular area.
These benefits will be positive for the local community. Examples:
- Employment
- Quality of life
- Providing a service
- Regeneration of land
External Costs - Negative Externalities
External costs created by businesses can impact the environment in the following ways:
- Urban blight – excessive development and inappropriate developments mean the environment is visually less attractive, loss of farmland
- Production and disposal of waste – this could include an increase in litter and rubbish from packaging
- Use of energy Pollution: Noise – from cars, lorries, factories etc
- Air – emissions from cars and delivery vehicles
- Land
- Sea
- Water
External Costs and Benefits in Production
- External costs are where MSC = MSB – MPC e.g. pollution, traffic congestion
- External benefits are where MSC < MPC e.g. research and development in industry, human resource development
External Costs and Benefits in Consumption
- External costs = where MSB e.g. anti-social behaviour, passive smoking, noise
- External benefits = where MSB > MPB e.g. public transport, vaccinations, attractive surroundings
Cost Benefit Analysis
- Identify all costs and benefits
- Measure the value of all costs and benefits
- Calculate the likelihood of costs and benefits
- Analyse the timing of the costs and benefits looking at present value
- Decide whether the project is worth undertaking
