What are externalities?

Definition: An externality is an unintended side effect that result from production or consumption of a good, affecting the third parties.

When the market experiences externalities, it fails to reach social optimum levels where Marginal Social Benefit is equal to Marginal Social Cost.


MSB is the extra benefit to society following the consumption or production of one extra unit of a good. MSC is the extra cost to society following the consumption or production of one extra unit of a good.

Externalities can be positive or negative and relate to production or consumption. A negative externality has a negative effect on society and produces a welfare loss. A positive externality is one which has an unintended positive effect on society and produces a potential welfare gain.

Examples of externalities:

Negative externality of consumption - Where Marginal Private Cost (MPC) is above the Marginal Social Cost (MSC). There is a welfare loss between MSC and MPC.

An example of this is cigarettes.

Negative externality of production - Where Marginal Private Cost (MPC) is above the Marginal Social Cost (MSC). There is a welfare loss between MSC and MPC.

An example of this is education.

Positive externality of production - Where Marginal Social Benefit (MSB) exceeds the Marginal Private Benefit (MPB). There is a potential welfare gain between MSB and MPB.

An example of this is the use of wind farms to generate electricity.

Negative externalities are a result of overconsumption or overproduction, while positive externalities are a result of underconsumption or underproduction. Governments may intervene to correct both of these.

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