Externality
When social costs/benefits differ from private costs/benefits.
Externalities
Key definitions
Negative externality
Social cost exceeds private cost.
Positive externality
Social benefit exceeds private benefit.
Marginal cost (MC)
Cost of producing one extra unit.
Marginal benefit (MB)
Benefit of consuming one extra unit.
MSC
Marginal social cost.
MSB
Marginal social benefit.
Socially optimum
Where MSB = MSC.
Market failure
Private market produces wrong quantity.
Third party
Affected without being part of transaction.
Key concepts
Negative production externalities cause overproduction vs social optimum.
Diagrams show welfare loss from too much output.
Government can tax, regulate or use permits.
Relevant tips
- Always identify third parties in externality examples.