Externalities seem to be everywhere! Little wonder that you probably won’t get through a micro exam paper without bringing externalities into your analysis and evaluative discussion! There is a lot to cover so start your revision early on this topic! You will need to be able to illustrate external costs and external benefits using marginal analysis, and then distinguish between the market and social optimum positions. Showing the welfare loss or gain areas are required as you analyse the effects of externalities from both production and consumption. One key evaluation point to remember – not all externalities are that important – but many are which is why this is a favoured topic for examiners.

1. Externalities from Production and
Consumption

2. Market Failure
Externalities from
Production and
Consumption

3. Externalities and Market Failure
• Externalities are spill-over effects
arising from production and
consumption for which no
appropriate compensation is paid
• Externalities lie outside the market
transaction / price
• Externalities cause market failure
if the price mechanism does not
take account of the social costs
and benefits of production and
consumption
• Externalities can be positive
and/or negative
Externalities are a major cause of market failure and occur in nearly
every market – be clear on effects for producers and consumers
Negative
Production
Externalities
Negative
Consumption
Externalities
Positive
Production
Externalities
Positive
Consumption
Externalities

4. Private and External Costs and Benefits
• Private costs are the costs faced by the producer or consumer
directly involved in a transaction
• Private benefits are the benefits for producer and/or consumer
directly involved in an economic transaction
• The existence of externalities creates a divergence between
private and social costs of production and the private and social
benefits of consumption
• Social Cost = Private Cost + External Cost
• Social Benefit = Private Benefit + External Benefit
• When negative externalities exist, social costs exceed private
cost. This leads to over-production and market failure if
producers do not take into account the externalities
• When positive externalities occur, social benefits exceed private
benefit – this can also lead to market failure

5. Summary of Private and Social Costs and Benefits
• Cost to the producing firm of producing an additional unit of output
Marginal private cost (MPC)
• Cost to third parties from the production of an additional unit of output
Marginal external cost (MEC)
• Total cost to society of producing an extra unit of output. MSC = MPC + MEC
Marginal social cost (MSC)
• Benefit to the consumer of consuming an additional unit of output
Marginal private benefit (MPB)
• Benefit to third parties from the consumption of extra unit of output
Marginal external benefit (MEB)
• Total benefit to society from consuming an extra unit, MSB = MPB + MEB
Marginal social benefit (MSB)

6. Calculating Social Costs & Social Benefits – An Example
New city
motorway
New schools
Airport
extension
New
hospitals
Private benefits 50 135 130 80
Private costs 120 80 100 65
Positive externalities 90 55 35 120
Negative externalities 60 20 60 45
Net private benefit -70 +55 +30 +15
Net social benefit -40 +80 +5 +90
A government is considering four investment projects. It has the
resources to finance and implement only one of these projects.
Net social benefit may be taken into account by a government when
deciding which project offers the best potential return for society

7. How do economists value externalities?
A key aspect of all externalities is the difficulty of assigning values
• Shadow pricing: e.g. the external cost of road congestion can be
calculated by multiplying the number of hours lost by the average
wage e.g. 1m lost working hours x £12 average hourly wage =
£12m
• Compensation: estimate the cost of ‘putting right’ an externality
e.g. include the cost of installing double glazing in houses affected
by increased road noise from a new motorway. If 200 houses are
affected each with £5,000 double glazing cost, increased road
noise is estimated at £1m
• Revealed preference: how much people are willing to pay to
avoid an externality e.g. if 200 householders are willing to pay
£2,000 each to avoid noise, the externality is valued at £0.4m

8. The Importance of Property Rights
• Property rights confer legal control or
ownership of scarce resources
• For markets to operate efficiently,
property rights must be protected
• Put another way, if an asset is un-
owned, no one has an incentive to
protect it from abuse / over-use.
• Failure to protect property rights may
lead to the Tragedy of the Commons
• Examples include the over use of
common land and the long-term decline
of fish stocks caused by over-fishing
which leads to permanent damage to
the stock of natural resources
Fish farms have
expanded in recent
years
Common land is
open for usage
without restriction

9. Get help from fellow
students, teachers and
tutor2u on Twitter:
@tutor2u_econ

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