Externalities-Open Access and Public Goods

Externalities-Open Access and Public Goods

An externality occurs when one person’s utility is affected (positively or negatively) by another person’s actions. We do not include in the definition of an externality the interrelationships between actions and utility which occurs indirectly via markets, but rather direct effects. One example of a negative consumption externality is one person’s smoking in a public room, which may be irritating or simply annoying, and at the same time downright harmful, to other persons in the same room. Another example is then my neighbor plays music so loud that I cannot sleep late at night.

An example of a negative production externality is when producer (firm) discharges polluted water into a stream, which reduces the stock of fish. Owners of fishing rights downstream will find that the value of their rights have been reduced due to the activity of the polluting firm.

Externalities can also be positive. Keeping your front yard clean and planting attractive plants will increase the attractiveness of the neighborhood, which may increase its value. This is a positive consumption externality. An example of a positive production externality is the classical case of honey producer and an apple orchard. The bees fertilize the apple trees and this increases the harvest for the apple grower, at the same time the availability of apple blossoms close to bee-hives will increase the production of honey. The positive externality therefore goes two ways in this case.

The problem with externalities is that the part responsible for the activity does not take it into account then deciding how much of it to do. For example, how many cigarettes to smoke, how long into the night to play music, how much polluted water to discharge into the stream? In the case of a negative externality, the activity imposes a cost on the receiving party, which the producing party does not take into account.

In the basic theory of markets, the supply curve of an output equals the producers’ marginal cost curve of producing the good, and to bring it to the market. If all inputs necessary to produce the output are bought on competitive markets they are all compensated by their opportunity cost and hence the total marginal cost of producing another unit of the good will be a correct measure of what society must give up producing, and consuming, another unit of the good. If the production is associated with a negative externality the marginal production cost does not include all costs and too much is produced. If the externality is a positive one, too little is produced.

Figure below illustrates the effect of a negative externality. The demand curve shows the marginal utility of an additional unit consumed, and the supply curve the marginal private cost (MPC) of producing an additional unit. The marginal external cost is often called the marginal damage and is denoted MD. In this case we assume that the marginal damage incurred is constant from the first to the last unit, but it may very well be increasing as well. If it is constant we get the marginal social cost by adding the marginal damage to the marginal private cost curve, i.e., we shift it up vertically. In an unregulated market the equilibrium will be {p0, q0}. The total surplus, if there had been no external cost, would as usual be the sum of the consumers’ and producers’ surpluses. However, in this case we have an additional cost to take into account, the external cost. The total external cost at the “free” market equilibrium is the area of the grey rectangle at the bottom of the diagram. This area is equal to the grey area between the MPC and the MSC curve from the origin up to q0 (including the cross-hatched triangle at the top). The Pareto-efficient level of output is q1 and the optimal price p1. This price take into account all cost of the production activity. The cross-hatched triangular area shows the efficiency cost, or dead – weight loss, of the overproduction at the market equilibrium; for all levels above q1 the marginal cost to society exceeds the marginal utility and hence results in a loss.


We conclude that the externality “problem” as viewed by economists is that too much is done of the activity with the negative external effect (too much production of the good), since the producer of the activity does not take the external cost into account. It is also important to note that just because an activity has a harmful side effect it doesn’t mean that it should be reduced to zero, but there is almost always a trade-off to be done between costs and benefits. In this case the marginal utility is much higher than the marginal cost for the first units produced, so society as a whole is better off if some production takes place, the optimal balance of costs and benefits are at the point where the marginal utility (or marginal benefit) equals the marginal social cost.

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