10.5: Externalities

We have shown that the private demand curve represents the private benefits consumers would receive if they consumed a product or service at alternative prices. But what does the private demand curve say about social benefits? That is, are the benefits to the direct consumers the same as the benefits to society from the consumption of the good or service? Usually, there are no benefits from consuming a particular good or service other than the benefits that the actual consumer receives (like with Joe eating cookies). However, there are times when positive externalities occur in consumption.

Externalities in Consumption: When the consumption of a good or service causes a change in satisfaction for someone other than the direct consumer of the item. Such externalities have positive or negative effects on society.

Suppose, for example, that a wealthy individual hires an accomplished orchestra to play at a party in her backyard and she does not invite her neighbors. This wealthy person is paying for music for the pleasure and benefit of her guests. But who is to stop her neighbors, possibly lovers of fine music, from listening to the beautiful melodies from their side of the property line? The consumption of the music by the wealthy individual and her party guests yields a positive externality (the benefits of the music are “spilling over” the fence and into the ears of the neighbors).

Whenever externalities in consumption exist, the private demand curve does not equal the social demand curve. See Figure 8.

Figure 8

Bottom line: When externalities exist, prices in the private market no longer reflect all benefits and costs associated with the consumption of a good or service.

Private Costs and Social Costs

We have shown that the private supply curve represents the costs associated with the production of a good or service at alternative prices. But what does the private supply curve say about social costs? That is, are the costs to the firms the same as the costs to society from the production of the good or service? Usually, there are no costs from producing a particular good or service other than the costs that the actual firm incurs.

Externalities in Production: When the production of a good or service causes a change in costs for someone other than the direct producer of the item. Such externalities have positive or negative effects on society.

Suppose a private electricity producer, ABC Power Company, operates a coal-fired power plant in Metro City. ABC Power Co. (i.e., a firm) employees over 1,000 people and provides electricity to 150,000 Metro City residents (i.e., consumers).

Research suggests that the sulfur dioxide emitted by coal-fired power plants during electricity production contributes to an environmental hazard called acid rain (acid rain is the result of sulfur dioxide mixing with moisture in the air). Many scientists claim that acid rain damages lakes and forests and corrodes automobiles, buildings, and other structures. Electricity production, therefore, imposes external costs on people other than the consumers (Metro City residents) and firm (ABC Power Co.) in the electricity market. In this case, electricity production yields a negative externality. In other words, the costs of the private production are spewing into the atmosphere and raining down on property belonging to people who are not involved in the market for Metro City electricity.

Whenever social externalities in production exist, the private supply curve does not equal the social supply curve. See figure 9.

Figure 9

External Costs Due to Pollution

In the case of ABC Power Co. pumping harmful sulfur dioxide into the atmosphere, the private costs of producing the electricity are less than the social costs. People other than the firms and consumers of electricity bear some of the costs of production. The external costs are not considered by ABC Power Co., and the consumers of the electricity don’t pay for them either. Instead, third parties (people in neighboring cities who own goods damaged by acid rain) bear the burden of this negative externality (i.e., external cost).

External costs exist whenever private costs are less than social costs. Any product or service that generates external costs is being subsidized, because others are paying for part of the production. And it is this subsidy that encourages over production of the goods.

Miscommunication

Prices act as signals to encourage firms to produce the things we value most – the right prices ensure that the economy maximizes the total welfare of its participants. When external costs exist the price people pay for the good is less than the cost to society to produce it. In other words, when external costs are present, the benefits (represented by the price consumers are willing to pay) of the good are less than the true costs of production. Therefore, output will exceed the level of that is a socially optimal. See Figure 10.

Figure 10

Figure 10 shows the excessive production that results when external costs are present in the production process. This over-production causes a misallocation of resources. Also pictured in figure 10 are the demand curve (social), supply curve (private), and supply curve(social) curve. The lower supply curve (private) represents only the costs incurred by ABC Power Co. when producing electricity.

The supply curve (social) represents both the costs incurred by ABC Power Co. and the costs incurred by others who have nothing to do with the market transaction (private costs + external costs = social costs). If ABC Power Co. is polluting and ignores these external costs, its supply curve is the supply curve (private). This yields an equilibrium price of $.20 per megawatt hour and an equilibrium quantity of 300,000 megawatt hours of electricity (point a).

At this price and quantity, the markets clear (i.e., supply equals demand) and ABC Power Co. maximizes its profits. However, the equilibrium rate of production and price are not at the socially optimal level. The social cost (private costs + external costs) of producing a megawatt of electricity at the level of 300,000 megawatt hours is $.40 (point b). However, consumers value the current rate of production at only $.20 per megawatt hour (the current market price).

If the external costs imposed on others are included in ABC Power Company’s cost calculations, the supply curve shifts to supply curve (social). Accordingly, the price will rise to $.30, and the amount produced will drop to 200,000 units (point c). Now, ABC Power Co. and consumers will pay the full cost for electricity production and consumption.

The failure of the private market to communicate the relevant costs and benefits of production and consumption leads to an inappropriate level of production (from society’s point of view). This situation causes the private market to waste scarce resources. This situation is considered a market failure.