Tuesday, 12 April 2011

Externalities (Microeconomics)

An externality, in the economic world, occurs when people not directly involved in a decision are affected by it. Some examples of this are fishermen may not be able to fish in a river if someone has contaminated it with rubbish or a new hospital being built will benefit all people in the local area. The term given to those not directly involved in the decision is third party. The third parties in the two examples I've given are the fishermen and the people in the local area.

Linked in with the externalities theory are the costs and benefits that come about from someones decision. The three types are private, external and social. Private costs/benefits are the costs and benefits to the person actually making the decision. Say i decided to pave over my front garden, the private cost would be me losing garden space but the private benefit would be extra parking space. External costs/benefits are the costs and benefits of a decision that someone makes that fall onto the third party. Continuing my example, the external cost of me paving my garden would be the street wouldn't like as nice to the neighbours and passers-by. The external benefits would be a clearer road for the neighbours to drive down because i could then park my car on the new paved area rather than in the street. Finally, the social costs/benefits are the total costs and benefits to society as a whole of the decision. The social cost equals the private costs plus the external costs.

External costs = Social costs - Private costs.
External benefits = Social benefits - Private benefits.

When the social cost is higher than the private cost it means there are external costs in play, these are known as negative externalities. Binge drinking, chewing gum and fly tipping all have negative externalities. The situation of a negative externality can be illustrated on a diagram...

The diagram represents our negative externality. The current equilibrium point is PQ, at this price we are at supply curve 'Supply' but this is only taking into account the private costs of the good. If the external costs are taken into account then the supply curve should shift leftwards to 'Supply 1'. This would raise the price to pay for the extra external costs, as well as lower the supply. The problem with negative externalities is that there is over-production of Q-Q1 and price is lower than it should be. Too many scarce resources are being used, so there is market failure.

Positive externalities work in the same way, this is when the social benefit of a decision is higher than the private benefit.Examples are vaccinations and education. They are the opposite of negative externalities, goods with positive externalities tend to be under-produced. If the external benefits were taken into account then the supply curve would shift to the right, lowering price and increasing production. The under-production here is another form of market failure.

Enjoy. :)

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