What are externalities?

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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 = MSC

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.

Elizabeth B. IB Economics tutor, IB English Literature tutor, GCSE En...

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