Externalities : A Closer Look
Externalities, externalities, externalities. What are they, and what relevance do
they have for me in my life as a student? Well, apart from you having to know
the ins-and-outs of them for your college exams (no pressure), they also play an
important role in society. Intrigued? Of course you are. Read on and you’ll be
an externalities expert in no time.
The Basics :
Externality = An activity which in?uences the well-being of a third party who
neither pays nor receives compensation for that effect.
Externalities cause markets to allocate resources inef?ciently. This is because
people only consider the private costs and bene?ts of their actions, they do not
consider the effect that these actions will have on society as a whole.
Externalities can be both positive and negative.
Let’s take for example the smoking habits of Fred, a ?rst year college student.
The private costs of smoking for Fred are the price of his cigarettes and the
effects that smoking will have on his health. The private bene?ts of his smoking
habit are him being able to receive his daily nicotine ?x, as well as perhaps the
social image that he obtains from being a smoker. However, is Fred aware of the
social costs of his smoking habits? As a result of his smoking he is polluting the
environment, affecting the health of those around him and may be indirectly
encouraging his younger peers to follow in his smoking habits in order to act
and be like him. All of these social costs must be incurred by third parties. In
this case, the private bene?ts Fred gets from smoking are less than the social
costs of his habit. Therefore, smoking creates negative externalities.
The social cost of Fred’s cigarettes takes into account both the private costs of
his smoking habit as well as the costs that must be incurred by third parties due
to his smoking. As a result of this, the social cost curve is always above the
supply curve in the supply and demand curves for negative externalities. The
difference between these two curves represents the social cost of Fred’s smoking
to society. When Fred’s demand for cigarettes crosses the social cost curve of
his smoking habit, the socially optimal quantity of cigarettes that he should
smoke will have been reached.