Chapter 13

Externalities

As we discussed in the chapter 11, externalities

are one of the ways that leads to market failure.

• Externalities are spillover effects from

production and consumption activity which
are no compensation is paid. ( definition)

• A cost or benefit of an economic activity

experienced by an unrelated third party. (definition)

*Third party are the people outside the

business or consumption.

Externalities are laid outside the initial market transaction; therefore, the cost or benefits
of externalities are not represented in the market price.
 Private benefits and Private cost
Private Benefits
Private Benefits are rewards of an economic activity, such as consumption or
production.
Private benefits of production Private benefits of consumption

Ex: The private benefit to a property Ex: person who consumes education can
developer of building the retail centre earn a good income to lead a decent life.
is the financial returns it makes from
the investment. Ex: Vaccination benefits the vaccinated
individual by preventing diseases.

Ex: The entertainment of watching movies

and series is the private benefit of
subscribing an online streaming service.
Private Costs
Private costs are costs of an economic activity to individuals and firms.

Private costs of production Private cost of consumption

Ex: The production of a car, private Ex: The private cost of consuming a cigarette
costs include the cost of labor, raw is the price a cigarette and other expenses
materials, and manufacturing (transport cost)
equipment.
Ex: The private cost of education is how
much is the tuition fee and other expenses.
 Types of externalities

Positive Externalities Negative Externalities

Positive Externalities Negative Externalities

(External Benefits) (External Cost)

A positive externality is a benefit from an A negative externality is a negative

economic activity experienced by an consequence of an economic activity
unrelated third party. experienced by an unrelated third party.

External benefits are positive spillover External costs are negative spillover effects
effects of consumption or production – of consumption or production – they affect
they bring benefits to third parties. third parties in a negative way.

Production Consumption Production Consumption

Positive externalities of production

• The construction of an airport creates many business opportunities.
• The construction of railway station may a shelter for some destitute people.
• Opening a new business create many other businesses and accommodation places for
their employee.
• Sri Lankan school create many business for MC Donalds, and create accommodation
spaces in the neighborhood.

Positive externalities of consumption

Education: education has external benefits
People are likely to get better jobs, earn more money and enjoy a better quality of life when they
consume education. However, education can also benefit the wider society. If people are well
educated, they may do highly skilled and socially useful jobs, such as doctors, teachers, pilots,
senior administrators or research scientists. As a result, productivity will be higher and the standard
of living of society as a whole will rise, and better education is help to reduce crime rate in the
society.
Healthcare: healthcare has external benefits
Individuals that consume health care will benefit if their own personal health improves. They will
feel less pain, can return to work and enjoy life more. Consumption of healthcare is benefited to
the wider society. If people are healthier, they are able to work more effectively making
contributions to economic output and paying taxes.

Vaccinations: vaccination has external benefits

If an individual receives an injection to protect against an infectious disease, he or she benefits
directly. This is obviously beneficial to the individual but third parties will also benefit. This is
because if more individuals are given vaccinations to prevent infection, the likeliness of others
(who do not get vaccinated) contacting disease is lower. This is because the number of people
who might pass on the disease is reduced because they have been vaccinated.

Negative externalities of production

Negative externalities of consumption

• Consuming alcohol leads to an increase in drunkenness, increased risk of car accidents
and social disorder.
• Consuming loud music late at night keeps your neighbours awake.
• Consuming cigarettes causes passive smoking to others in the vicinity.

Social Costs Social Benefits

Social costs are costs of an economic Social benefits are benefits of an
activity to society as well as the economic activity to society as well as to
individual or firm. the individual or firm.

Social Cost = Private Cost + External Costs (Negative Externalities)

Social Benefits = Private Benefits + External Benefits (Positive Externalities)

Government policies to deal with externalities
1) Taxation
Taxes can be imposed to reduce the external costs of production.
When a tax imposes on a product that generates negative externalities, the cost
of production increase and then price increases. As a result, when the price
increases the demand decreases and reduces the production.

Taxes can be imposed to reduce the external cost of consumption.

When a tax imposes on a product that generates negative externalities at
consuming, such cigarette consumption and harmful products, the supply falls
and then the price of the product increases. When the price increases, the
quantity demand decreases, and reduces the negative externalities of
consumption.

However, imposing taxes on cigarette is not a successful way to control the

negative externalities of consumption as people who use cigarettes are addicted
to the products and therefore the demand is price inelastic. Thus, the price
increases due to taxes on the product, may not fall the demand very much.

2) Subsidies
Subsidies can be granted to reduce negative externalities as well as to encourage positive
externalities.
A government can grant any form of subsidy as an incentive to reduce external
costs (negative externalities) of production.

Or else government can grant a subsidy to encourage positive externalities of

production. When a government grand a subsidy the supply increases and price
decrease, as a result demand encourage and demand increases. For example,
subsidies for university education may encourage more people into higher
education. As a result, the wider society will benefit from a better educated
population.

However, government subsidies involve with opportunity cost. The money that
spent by government on subsides to encourage positive externalities or to
reduce negative externalities might be spent more effectively on other
government projects such as education, road development and healthcare
development.
3) Fines
There is a system in some countries to fine on negative externalities.
Ex: Discarding or leaving waste, garbage bags, or empty containers outside public shops or
designated containers. Penalty: QR 10,000

4) Government regulations
Government can pass more legislations to protect environment. In recent years,
because of the growing concern of environmental protection and specially
about global warming, there is a pressure on all the governments around the
world to pass legislations that can be enforced to protect environment.

Ex: Government announces to ban the supply and sale of wet wipes containing plastic.

5) Pollution Permits
Some governments issues pollution permits to firms. This document gives
businesses a right to discharge a certain amount of polluting materials. These
permits are tradable and firms can sell these permits to other firms. Therefore,
the firms which have pollution permits tries to minimize their pollution level and
sell it to another firm. This makes profits for firms so they try new technologies
and methods to mitigate their pollution level.
However, a government cannot issue any number of pollutions permits to firms
as every country has agreed with the level of carbon dioxide that they can
maximum emit to the atmosphere in Paris Agreement. They need to decide how
many pollution permits are to be issued.
As pollution is difficult to measure, governments may end up issuing too many
pollution permits or less pollution permits. Also the administration cost of
pollution permits are high and businesses may disguise their level of pollution
if it is difficult to measure.