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Externality

Externalities are a broad type of market failure occurring when one party’s welfare is influenced by their own activities and that of another party.
Silhouette of a smoke stack of a power plant billowing black smoke against a cloudy sky.
© Deakin University

Market failure is also often due to the presence of externalities.

This is a broad type of market failure. It can occur when one party’s welfare is influenced not just by their own activities, but also the activities of another party. This other party may act in a way that imposes costs on the first party (among others).

  • On a local scale, a factory may pollute the surrounding areas without considering the cost to communities.
  • On a wider scale, motor vehicles create air pollution. The cost of this pollution falls on the rest of society – whether or not they own a vehicle – and not just the producers or users of motor vehicles.
  • On a global scale, one country’s actions can often have costs that impact other countries.

We can visualise an external cost of a power plant in the following diagram. Power production inevitably creates pollution (cost) as well as electricity (benefit).

Horizontal axis is quantity; vertical axis is price. Demand (D) is plotted from maximum price to maximum quantity. MPC starts at a low price and slopes upwards. MSC starts at slightly higher price and slopes upwards at a slightly sharper angle. MPC and D intersect at quantity m and price m. MSC and D intersect at quantity Q* and price P*. Adapted from Lewis, L., & Tietenberg, T. H. (2018), Figure 2.5.

The demand for power is shown by the demand curve (D). The marginal social benefit (MSB) to society for electricity is the sum of individual demand.

The marginal private cost (MPC) to the company producing electricity is represented by the MPC curve.

Decision makers will consider both the cost of pollution and the cost of producing electricity, so the marginal social cost (MSC) function includes both the MPC and the external cost to society: the externality.

If the power plant wanted to maximise its producer surplus, it would produce Qm units of electricity. However, with the externality factored in, the net benefit is maximised at Q*.

Share your thoughts

Externalities can be positive. For instance, education can be a positive externality to society (Schwarz, P. M., 2018).

Find another example of an externality, either positive or negative, and describe it in the comments.

References

Lewis, L., & Tietenberg, T. H. (2018). Environmental and Natural Resource Economics (11th edition.). Routledge.

Schwarz, P. M. (2018). Energy economics. Routledge.

© Deakin University
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Introduction to Environmental Cost-Benefit Analysis

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