Externalities
Definition
Externality: a spillover cost or benefit from the production or consumption of a good that falls on third parties and is not reflected in the market price.
Negative externality: a spillover cost imposed on third parties, so social cost exceeds private cost (or social benefit falls short of private benefit).
Positive externality: a spillover benefit enjoyed by third parties, so social benefit exceeds private benefit (or social cost falls short of private cost).
What an externality is
- The spillover lands on outsiders, so it is not built into the market price buyers and sellers respond to → the price signal is distorted.
- Private agents weigh only their own private costs and benefits and ignore the external ones → private and social valuations diverge.
- It depends on where the spillover occurs: externalities can arise in both the production and the consumption of a good, giving several distinct cases.
Key Idea
- Social cost = private cost + external cost, and social benefit = private benefit + external benefit.
- Where social and private values diverge, the free-market quantity is not the efficient one.
Negative externalities
- A negative externality is a spillover cost imposed on third parties by production or consumption → someone outside the deal is made worse off.
- It makes marginal social cost exceed marginal private cost (MSC > MPC), or marginal social benefit fall below marginal private benefit.
- Because decision-makers ignore this external cost, the free market over-produces or over-consumes → output lies beyond the efficient level.
Example
- A factory's air pollution forces nearby residents to meet healthcare and cleaning bills the firm never pays.
- Passive smoking imposes health costs on bystanders who take no part in the purchase.
Positive externalities
- A positive externality is a spillover benefit enjoyed by third parties from production or consumption → someone outside the deal is made better off.
- It makes marginal social benefit exceed marginal private benefit (MSB > MPB), or marginal social cost fall below marginal private cost.
- Because decision-makers ignore this external benefit, the free market under-produces or under-consumes → output falls short of the efficient level.
Example
- Vaccination lowers disease spread, protecting people who are not themselves vaccinated.
- Education raises the wider economy's productivity, not just the learner's own earnings.
Worked calculation
Example
- A power station's marginal private cost = £40; its pollution adds a marginal external cost equal to 25% of that, so MEC = £10.
- Marginal social cost = £40 + £10 = £50, while marginal social benefit = marginal private benefit = £44.
- MSC £50 > MSB £44 on the last unit, so society loses £6 there → the negative externality drives over-production.
Note
- Because externalities occur in both production and consumption, there are four distinct cases, set out in the next article.
Exam technique
- Identify the third party first and state whether they gain or lose.
- Link that to whether social cost or social benefit diverges from the private value.
- Use MSC, MPC, MSB and MPB precisely to secure the analysis marks.
Common Mistake
- Do not call an effect on the buyer or seller themselves an externality.
- A cost or benefit only counts as external when it falls on someone outside the transaction.
Self review
- Define an externality in one sentence.
- Explain why a negative externality means MSC exceeds MPC.
- Does a free market over-produce or under-produce a good with a positive externality?
- Give one example each of a negative and a positive externality.
