UNIT
5 Microeconomics LESSON 2 ACTIVITY 54
Externalities
A market externality refers to a situation where some of the costs or benefits from an activity fall on
someone other than the one pursuing the activity. Externalities may be either positive (the activity
provides a benefit to someone else) or negative (the activity places a cost on someone else). Costs that
fall on someone else are called external or social costs, and benefits that fall on someone else are called
external or social benefits.
Total cost = Private cost + Social cost
Total benefit = Private benefit + Social benefit
Externalities are sometimes referred to as third-party costs or third-party benefits, when they fall on
a third party: someone outside the transaction, not one of the buyers or sellers in a market.
In the presence of externalities, the demand curve still represents the private marginal benefit of a
given unit, and the supply curve represents the private marginal cost. Now, however, we need to dif-
ferentiate among the total, private and social components of costs and benefits.
For decision making on the margin, we can rewrite the above equations as
MCT = MCP + MCS
MBT = MBP + MBS
(Careful here, the terminology may be different in your book. For example, in many textbooks, the
marginal social cost encompasses the private and nonprivate components.)
Activity written by Margaret Ray, Mary Washington College, Fredericksburg, Va.
Advanced Placement Economics Microeconomics: Student Activities © National Council on Economic Education, New York, N.Y. 279
UNIT
5 Microeconomics LESSON 2 ACTIVITY 54 (continued)
Figure 54.1 Figure 54.2
External Benefits External Costs
MCT = MCP + MCS
MCT = MCP
COSTS/BENEFITS
COSTS/BENEFITS
QSocial
MCP
QSocial
MBT = MBP + MBS
MBP MBT = MBP
1 2 3 4 5 6 1 2 3 4 5 6
HOURS OF MUSIC HOURS OF MUSIC
1. Imagine you live with a roommate in a college residence hall. Your roommate has brought an
expensive stereo system to play in your room. Figure 54.1 shows your roommate’s private margin-
al cost (MCP) and marginal benefit (MBP) curves for music played on the stereo system. Based on
your roommate’s private costs and benefits from playing music, answer the following questions.
(A) If your roommate considers only the private costs and benefits from playing music, how
3
many hours of music are played? _______ Label the number of hours QPRIVATE on the graph.
(B) Assume that your roommate plays music only at times that do not disturb you and plays only
music that you also enjoy. The dashed line shows that MBT exceeds MBP. Therefore, how do total
They are greater
benefits (social benefits plus private benefits) differ from private benefits? ___________________
If your roommate considers the social benefits from playing music as well as the private benefits,
increase to 4
what happens to the quantity of music played? _____________________________. Label the
number of hours QSOCIAL on the graph.
(C) Now assume that your roommate plays music only at times that you are trying to study and
plays only music that you hate. The dashed line on Figure 54.2 shows that MCT exceeds
MCP. If your roommate considers the social costs from playing music as well as the private
decrease
costs, what happens to the quantity of music played? _______________________________
Label the number of hours QSOCIAL on the graph.
(D) When your roommate does not consider your external benefits in the absence of external
costs from playing music, the number of hours played is (efficient / too high / too low). When
your roommate does not consider your external costs in the absence of external benefits, the
number of hours played is (efficient / too high / too low).
280 Advanced Placement Economics Microeconomics: Student Activities © National Council on Economic Education, New York, N.Y.
UNIT
5 Microeconomics LESSON 2 ACTIVITY 54 (continued)
(E) How can government regulation (in this case, residence-hall rules) assure the efficient
quantity of music? Consider the circumstances under which prohibiting stereos or imposing
daily “quiet hours” are efficient ways to regulate stereo use in the hall. Does economics suggest
a more-efficient approach to stereo regulation?
Banning stereos or setting quiet hours won't lead to an efficient outcome because it overlooks
external benefits and costs. A better solution would be to assign property rights for stereo use,
allowing parties to negotiate the number of hours it can be played. For instance, if there's a
negative externality, Wendy could compensate Margaret, while if there's a positive externality,
Wendy could charge Margaret.
2. For each of these activities, explain whether there is a positive or negative externality:
Private high school education
Positive because bettere education and learning
Smog from an electric power plant
Negative because of health issues
Your neighbor’s yappy dog
Negative because loud noise annoys people
Prekindergarten measles vaccinations
Positive because the kids wont spread disease
3. The Women’s National Basketball Association (WNBA) has awarded a new franchise for a basket-
ball team to be established in Metropolis, but only if the new team has a new arena in which to
play. Proponents of the franchise argue that the team will generate new business, provide jobs,
increase tax revenue and promote tourism in Metropolis. Opponents argue that most of the
money spent on basketball games will come from Metropolis-area residents who will simply
reduce their spending on other activities. Thus there will be few new jobs, little increase in tax
revenue and few new tourists coming to Metropolis. Others say the new stadium will cause
property values to fall and create traffic, parking and noise problems.
Voters have the following three proposals before them:
Proposal 1: No city money should be used in the construction of the arena.
Proposal 2: The city should place a tax on each ticket sold to pay for the arena.
Proposal 3: The city should build the arena and lease the right to play there to the basketball team
at a subsidized rate.
Using your knowledge of externalities, answer the following questions.
(A) What assumption does Proposal 1 make about the size of external costs compared with exter-
nal benefits? Explain.
This assumes there are no externalities, positive or negative. The benefits of the franchise go solely to ticket buyers, with no
spillover benefits. Similarly, the team bears the costs of the franchise and arena with no external costs. In this scenario, MPB
= MSB and MPC = MSC. When the market produces where MPB = MPC, it also achieves the socially optimal output where
MSB = MSC.
Advanced Placement Economics Microeconomics: Student Activities © National Council on Economic Education, New York, N.Y. 281
UNIT
5 Microeconomics LESSON 2 ACTIVITY 54 (continued)
(B) How does Proposal 2 change the composition of total costs and benefits to adjust for external-
ities (both positive and negative)?
Proposal 2 adjusts for externalities by placing a tax on each ticket sold. This tax
accounts for both the positive and negative externalities, such as the congestion and
noise from the arena (negative) or the potential economic benefits from increased
tourism (positive). The tax helps align the private costs with the social costs, thus
improving market efficiency.
(C) What assumptions does Proposal 3 make about external costs and benefits to reach an
efficient solution?
Proposal 3 assumes that the external benefits of the arena (such as increased tourism and business) outweigh
the external costs (like traffic or noise). By building the arena and leasing it to the team at a subsidized rate, the
city aims to encourage the creation of the arena, fostering positive externalities that benefit the city’s economy
and attracting more visitors.
Summary
4. When positive externalities are involved, private markets (underproduce / overproduce).
5. When negative externalities are involved, private markets (underproduce / overproduce).
6. Why do economists refer to the presence of an externality as a market failure?
Economists refer to the presence of an externality as a market failure
because the market fails to allocate resources efficiently, leading to
overproduction or underproduction of goods or services.
7. How would a tax remedy a negative externality?
A tax would remedy a negative externality by internalizing the cost,
making producers or consumers consider the social cost of their actions.
8. How would a subsidy mitigate underproduction in the presence of a positive externality?
A subsidy would mitigate underproduction in the presence of a positive
externality by encouraging more production or consumption of a good that
has beneficial spillover effects for society.
This assumes there are no externalities, positive or negative. The benefits of the franchise go solely to ticket buyers, with no
spillover benefits. Similarly, the team bears the costs of the franchise and arena with no external costs. In this scenario, MPB
= MSB and MPC = MSC. When the market produces where MPB = MPC, it also achieves the socially optimal output where
MSB = MSC.
282 Advanced Placement Economics Microeconomics: Student Activities © National Council on Economic Education, New York, N.Y.
