Concepts of Externalities

Chapter Summary:

An externality increases when one party directly expresses a benefit or cost to others. A network externality occurs whenever a benefit or cost directly conveyed to others based on the total number of other users. An item is a public good when one person’s raise in consumption doesn’t decrease the quantity available to others. Equivalently, a public good gives non-rival consumption.

The benchmark for public goods and externalities is economic efficiency. At that point, all parties maximize their total benefits. Externalities can be solved via unilateral or joint action; however resolution might be hampered by the differences in information and free riding. Likewise, the commercial provision of a public good based on being able to eliminate free riders. Excludability based on law and technology.

The markets with network externalities vary from conventional markets in many ways.  Demand is not significant until a critical mass of users is established. The expectations of potential users aid to find out the attainment of critical mass.  
Key Concepts:


General Chapter Objectives:

A) Discuss negative and positive externalities, and their economically proficient level.

B) Describe why it is gainful to solve externalities, and how to do so.

C) Recognize network externalities and apply the idea to the Internet and e-commerce.

D) Differentiate the managerial implications of markets with network externalities from the conventional markets.

E) Discuss the idea of a public good and its economically proficient level.

F) Observe the role of technology and law in excluding users from the public good.

1) Externalities: Benchmark.

a) An externality occurs whenever one party directly (instead of through a market) conveys a profit or cost to others.

i) The existence of an externality implies the relevant market doesn’t exist.

ii) A positive externality occurs whenever one party directly conveys the benefit to others, example: additional business produced by a new store to the existing shops.

iii) A negative externality occurs whenever one party directly imposes a cost to others, example, business taken away by a latest store from the existing shops.

b) In deciding the levels of investments which give mount to externalities:

i) When the source considers only the advantages and costs to it, and ignores the advantages and costs to others, that are, ignoring the externalities.

  • It maximizes gain where individual marginal benefit equivalents individual marginal cost.

ii) Whenever the source considers the costs and benefits of an externality to its group of members:

  • The group marginal benefit curve from an externality is vertical sum of the individual marginal benefits.
  • When one party produces positive externalities, the group maximizes gain where the group marginal benefit equivalents the marginal cost of the activity producing the externality.
  • Group marginal cost curve from an externality is the vertical sum of individual marginal costs.
  • When one party produces negative externalities, the group maximizes gain where the individual’s marginal benefit from the activity producing the externality equivalents the group marginal cost.

c) Benchmark level of an externality:

i) When one party produces both negative and positive externalities, the group maximizes gain at the following benchmark: where the sum of marginal benefits from the activity producing the externalities equivalents the sum of the marginal costs.

  • This is the economically proficient level (that is, of the activity producing the externalities).
  • It is the point where an externality is solved.

ii) Assume the marginal benefits surpasses the marginal cost of a positive externality, there is a gain opportunity for an intermediary to collect fees from the recipients (that is, up to their respective marginal benefits) to pay the source (that is, an amount adequate to cover the source’s marginal cost) to raise the externality.

iii) The similar benchmark applies whenever the source is separate from the recipients.
2) Resolving an externality:

a) Includes deliberate action, not accomplished via the market.

b) The merger of source and recipient of an externality.

i) Once the source and recipient of the externality are joint, no matter who acquires whom, the solitary entity will take account of all costs and benefits of its investments and invest up to the economically proficient level (that is, group marginal benefits equivalent group marginal costs).

c) Joint action: Where merger is not feasible:

i) The source and recipient of the externality could negotiate and solve the externality (whereas remaining separate entities).

  • They collect information on costs and benefits to the different parties and plan the level of activity which generates the externality.  
  • Example: in the case of a positive externality, the recipient will pay the source (that is, a contribution equivalent to the recipient’s marginal benefit from the activity producing the externality) to raise the source’s investment.  
  • The source will maximize gain by selecting the level of activity where marginal benefits equivalent marginal costs.

ii) Then, they should enforce the agreed plan: monitoring the source and applying incentives to make sure that the source obeys with the planned level of activity.

d) Free riders:

i) A free rider is a party which contributes less than its marginal benefit to the resolution of the externality.
ii) Informational differences and free-riders hamper the resolution of an externality.

Information differences on advantages make it hard to ascertain whether a recipient is bluffing (that is, claiming a lower benefit and attempting to make a smaller contribution in the joint action).

2) It might be costly to prohibit certain parties from receiving a benefit, particularly whenever the externality affects numerous recipients and the recipients vary broadly in their marginal benefits.

3) Network effects or externalities.

a) A network externality occurs whenever a benefit or cost directly conveyed to others based on the total number of other users. The adjective network emphasizes which the externality is produced by the whole network of users.

i) Network externalities describe the growth of the Internet and other communications methodologies.

ii) In the existence of network externalities, marginal benefit and demand based on price, income, prices of associated products and the total number of other users.

iii) When the network externality is not totally solved, there exist opportunities for gain from solving the difference among the sum of marginal benefits and the sum of marginal costs.

b) A network effect occurs whenever a benefit or cost based on the total number of other users. There is a market to solve the network consequence.

c) Distinguishing characteristics of markets with network externalities or effects (in respect of conventional markets).

i) In the presence of network externalities or effects, demand is not significant till a critical mass of users is established.

  • Critical mass is the number of users at which, the quantity demanded becomes positive.
  • An alternative way to evaluate the size of critical mass is the size of installed base, the quantity of complementary hardware in service.  

ii) Expectations of potential users aid to find out the attainment of critical mass. Expectations can be influenced via commitments and hype.

iii) Demand in markets with network externalities or effects is very sensitive to small differences between competition and such markets are more probable to tip.

  • Tipping is the tendency for the market demand to shift in the direction of a product which has gained a small original lead in user base.
  • This is unlikely that some competing products will coexist.

d) The existence of network externalities or effects influences the price elasticity of demand.

i) Market demand:

  • Whenever market demand is beneath critical mass, demand is zero, and very price inelastic.
  • Whenever demand surpasses critical mass, the network externality or effect tends to amplify the consequence of a price change on quantity demanded and causes demand to be comparatively more elastic.

ii) Relation between competing sellers:

  • When all competing products have achieved a critical mass of demand, the market demand could tip in favor of one, and individual demand for each and every product will be very price elastic.

4) Public goods:

a) There is a continuum between non-rival, rival consumption and congestible.

i) Consumption is non-rival when one person’s raise in consumption does not decrease the quantity accessible to others, that is, a public good (like fireworks).

ii) The consumption is congestible when one person’s raise in consumption by some quantity decreases the total quantity accessible to others however by less than that quantity, example: Internet usage, various forms of entertainment.

iii) Consumption is rival when one person’s raise in consumption decreases the total accessible to others by similar quantity, that is, a private good (like clothing and food).

b) Provision of a public good:

i) Content in relation to delivery:

  • Content is forever a public good.
  • Delivery might be a public good (that is, delivery by over the air transmission unless excluded through certain technology) or a private good (that is, delivery through cable).

ii) There is a great economy of scale in offering a public good. Provision includes only a fixed cost and the marginal cost of serving extra consumers or users is zero.

iii) Economic efficiency: Whenever vertical sum of marginal benefits equivalents the marginal cost. Opportunities for gain from adjusting provision are exhausted at that point.

iv) Excludability: (It is the basis for commercial provision of numerous public goods is to convey them in the format of private goods.)

  • This is a basic condition for the commercial production of any product. (Or else free riders will cut into the seller’s profits, revenues and hamper provision). Consumption is excludable when the provider can prohibit particular consumers.  
  • Excludability based on law (that establishes excludability via intellectual property) and the cost of enforcement.
  • Excludability based on technology, example: scrambling technology, access through passwords.
  • Note that law and technology modify with time and place.


In several countries, betting shops are permitted in general retail regions. A betting shop can attract a big volume of customers, who might spill over to other close by businesses. On the other hand, the existence of a betting shop might hurt toy stores and other businesses which target children and women.

a) On an appropriate diagram, state the marginal benefit and marginal cost of investment by a betting shop, the marginal benefit or cost to a bar, and the marginal benefit or cost to a toy store.

b) What rent would the owner of the shopping mall charge to a betting shop in comparison to a bank?

c) Do you expect to find comparatively more betting shops in malls or on the open streets?



a) The figure is as shown above. The bar receives a benefit, whereas the toy store acquires a cost.

b) The usual shopping mall targets families. A bank would produce positive externalities to the other stores in shopping mall. A betting shop would produce negative externalities. The mall owner would charge the betting shop a high rent than the bank?

c) On open streets, betting shops are less probable to be subject to higher rents. Therefore they tend to place on open streets instead of malls.

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