8  Externalities

Objectives

  1. Identify positive and negative externalities
  2. Identify if the externality comes from the cost (supply) or benefit (demand) side
  3. Implement equilibrium in market diagram and identify equilibrium and socially optimal quantities
  4. Know correct policy to correct for externalities

Our standard market equilibrium includes only two characters: the consumer and producer. This section studies externalities, when the production or consumption of a good impacts a bystander.

8.1 Positive and Negative Externalities

Positive Externality

Positive Externality: A side effect that benefits bystanders

Positive Externality
Negative Externality

Negative Externality: A side effect that harms bystanders

Negative Externality

8.2 Equilibrium and Socially Optimal Quantities

Equilibrium Quantity

The quantity determined by private costs and benefits.

Socially Optimal Quantity

The quantity determined by social costs and benefits.

Positive Demand Externality Negative Supply Externality

Type of Curve Quantity
Private Benefit / Cost Equilibrium Quantity
Social Benefit / Cost Socially Optimal Quantity
Externality Optimality
Negative Overproduction
Positive Underproduction

8.3 Policy: Correcting for Externalities

Positive Demand Externality: Corrective Subsidy

Positive Supply Externality: Corrective Subsidy
Externality Tax Policy
Negative Tax
Positive Subsidy

8.4 Conclusion

  • This lecture studies externalities, side effects that benefit or harm bystanders
  • Externalities can modify the benefits (demand side) or costs (supply side) of bystanders
  • We can correct for them by introducing taxes and subsidies