Assignment

of

Advanced Economic theories and policies

 Title: Externalities
Name – Jashandeep Kaur
Roll no – 251707002
Discipline – Economic
Submitted To – Dr. Harmeet Kaur
Mam
Submitted By – Jashandeep kaur ( phd.
Scholar)
Meaning and types of Externalities
In the course of producing and consuming some commodities, harmful or
beneficial side effect that is borne by the people not directly involved in the
production and consumption of the commodities. These side-effects are called
externalities. It is also called spill over effect

There are two types of Externalities

 Positive externalities: Social benefits are called positive externalities. If any

activity generates positive externalities social welfare will increase. For
example, Mr. Mohan maintains a beautiful garden and Mr. Shyam
(neighbour of Mr. Mohan) enjoys it. It adds to welfare of Mr. Shyam but he
does not pay for it, it is the example of positive externalities .
 Negative Externalities: Social harm /costs are called negative externalities.
If negative externalities are generated, social welfare will fall. For example,
Environmental pollution caused by industrial plants. It causes a loss of social
welfare. It is the example of negative externalities

Nature of Externalities
 Produced by firms and consumers: Externalities can be produced by both
firms and consumers. For example, by a firms, any factory which emits
smoke leading to air pollution. By a consumer, who smoked cigarette
leading to depletion of fresh air for other.
 Reciprocal in nature: Externalities are reciprocal in nature. Your activities
can affect other can also affect you. For example, if you don’t wear mask
during COVID-19, it put a negative externalities on other. Similarly, if other
don’t wear mask it affect you .
 Can be Positive: Mr. Mohan maintains a beautiful garden and Mr. Shyam (
neighbour of Mr. Mohan ) enjoys it . It adds to welfare of Mr. Shyam,
instead he does not pay for it , it is the example of positive externalities .
 Public goods a special Externalities : When an individual creates a
positive externalities with full effects being enjoyed by entire economy ,
then it is called as public good for example , I install in my backyard a
device for electrocuting mosquitoes . If I kill the whole community’s
mosquitoes than I have created a public good
Externalities can lead to market inefficiencies because the ,market may not fully
account for the social costs or benefits associated with the economic activity .
As a result, there may be overproduction or underproduction of certain goods
and services, and market may fail to allocate resources efficiently
.policymakers may intervene to address externalities through regulations , taxes,
subsidies , or other measures to internalize the external costs or benefits and
promote a more socially optimal outcome.

Externalities can occur in production or consumption

(1) Positive externalities in consumption

(2) Negative externalities in consumption

(3) Positive externalities in production

(4) Negative externalities in production

Marginal analysis looks at the benefit or cost we receive from consuming or

producing one more unit

 Marginal benefit is the benefit to a consumer of consuming one more unit

of a good or service
 Marginal cost is the cost to a producer of producing one more unit of a
good or service
 Marginal benefit:- consumer:- Demand:- Downward
 Marginal cost:- producer/firm:- Supply:- Upward
 Marginal benefit =Marginal Private Benefit
 Marginal cost = Marginal Private cost
Marginal Private Benefit

Marginal private benefit (MPB) is the additional amount of satisfaction that a

consumer gains from an additional unit of a good or service

Marginal Private Cost

Marginal private cost (MPC) is the cost to a producer of producing an additional

unit
  MSB includes MPB but also the additional benefits to society of
consuming or producing one extra unit
 We call these marginal external benefits (MEB)
MPB + social benefit = MSB
 MSC includes MPC but also the additional costs to society of
consuming or producing one extra unit
 We call these marginal external costs (MEC)
MPC + Social cost = MSC

MPB=MPC equilibrium condition

 Positive Externality in consumption

A positive Externality in consumption occurs when the consumption of a good

or services by one individual or group has positive effects on others who did not
directly participate in the consumption. In the other words, the benefits of
consuming the good or service spill over to Individuals or society beyond the
immediate consumer.

1. Education: if an individual receives education ,not only does it benefits

them directly by enhancing their and knowledge, but it also benefits
society. A more educated population often leads to higher levels of
innovation, productivity, and a better-informed citizenry
2. Vaccination: when individuals get vaccinates against contagious
diseases, they not only protect themselves but also contribute to the
overall public health by reducing the spread of the disease. This benefits
 those who may not have been vaccinated, such as individuals with
weakened immune systems

Diagram showing positive Externality in consumption

1. The consumer gains the benefit of consuming a good or service on the

demand curve D (MPB).

2. Social benefit is above and to the right of private benefit (D1) (MSB) as the
benefits to society of a positive externality will be greater than the benefits to
the individual consumer.

3. A consumer will maximise its private benefit by consuming where S =

D(MPC=MPB) at PQ. However, if social benefits were included we would
operate where S = D1 (MPC/MSC=MSB) at P1Q1.

4. The consumer's optimal level of output is Q. Society's optimal level of output

is Q1. Therefore, society is benefiting over and above the individual consumer
by Q- Q1. The consumer is underconsuming.

5. The benefit to society (or welfare gain) can be seen by the blue shaded area.
This measures the difference between social benefit and private benefit at
output levels between Q and Q1.

 Negative externality in consumption

A negative externality in consumption occurs when the consumption of a good

or service by one individual or group has adverse effects on others who did not
participate in the consumption. In other words, the cost associated with
consumption is borne by immediate consumer.

1. Smoking: individuals who smoke not only harm their health but also
expose others to second-hand smoke. This can lead to health issues for
non- smokers, resulting in increased health care cost for society
2. Noise pollution: loud activities, such as playing loud music or using
noisy equipment, can disturb neighbours and negatively impact their
quality of life. The individuals causing the noise may not fully bear the
costs imposed on others

Diagram showing negative externality in consumption

1. The consumer gains the benefit of consuming a good or service on the

demand curve D(MPB).

2. Social benefit is below and to the left of private benefit as the benefits to
society of a negative externality will be lower than the benefits to the individual
consumer.

3. A consumer will maximise its private benefit by consuming where S =

D(MPC=MPS) at P1Q2.

4. However, if social benefits were included we would operate where S = D1

(MPC/MSC=MSB)at PeQe.

5. The consumer's optimal level of output is Q1. Society's optimal level of

output is Qe. Therefore, the consumer is overconsuming by Q1-Qe
6. The loss of benefit to society (or welfare loss) can be seen by the blue shaded
area. This measures the difference between social benefit and private benefit at
output levels between Q1 and Qe.

 Positive externality in production

A positive externality in production occurs when the production of good and

service by one firm has positive effects on the others who did not participate in
the production. In other words, the benefits of producing a particular good or
service spill over to individuals or society beyond the immediate produces.

1. Green technology and environmental practices: Firms that adopts

environmentally friendly production methods and technologies contribute
to the overall reduction of environmental pollution. This benefits not only
the firm itself but also the surrounding community and society by
improving air and water quality
2. Infrastructure development: when a firm invests in building
infrastructure, such as roads or utilities, it not only facilitates its
operations but also benefits other businesses and residents in the area by
improving transportation and access to services.

Diagram showing positive externality in production

1. S1 (MSC) is down and to the right of S(MPC) as the costs to society of a

positive externality will be less than the costs to the producer.

2. If social costs were included i.e. the full costs then we would operate where
S1 = D (MSC=MCB/MPB) at P1Q1.
3. The benefit to society (or welfare gain) can be seen by the blue shaded area.
This measures the difference between the social cost and private cost at output
levels between Q and Q1.

4. The firm's optimal level of output is Q. Society's optimal level of output is

Q1. Therefore, the firm is under producing by Q-Q1.

5. Price is too high and output too low. There is allocating inefficiency.

 Negative externality in production

A negative externality in production occurs when the production of a good or

service by one firm has adverse effects on others who did not participate in the
production. In other words, the costs associated with the production are borne
by individuals or society beyond the immediate produces.

1. Water pollution from industrial processes: discharging pollutants into

waters bodies during industrial production can contaminate water
sources. This negatively Affects aquatic ecosystems and can harm the
health of individuals who rely on those water sources for drinking or
other purposes.
2. Noise pollution: some industrial activities, such as manufacturing or
construction, generate significant noise. This can disturb nearby residents,
affecting their quality of life and potentially leading to negative health
consequences.

Diagram showing negative externality in production

1. In the diagram, the supply curve S (MPC) takes into account the cost to the
firm of producing the product i.e. the private cost.

2. If we include the cost to society the supply curve would shift up and to the
left (S1) (MSC) as the costs to society of a negative externality will be greater
than the costs to the producer.

3. If social costs were included i.e. the full costs then we would operate where
S1 = D (MSC=MSB/MPB) at P1Q1.

4. The cost to society (or welfare loss) can be seen by the blue shaded area. This
measures the difference between the social cost and private cost at output levels
between Q and Q1.

5. The firm's optimal level of output is Q. Society's optimal level of output is

Q1. Therefore, the firm is overproducing by Q-Q1.

6. Price is too low and output too high. There is allocating inefficiency.