(...) However sometimes the production and consumption activities cause an external effect that generates costs or benefits to the third parties. These effects can be negative or positive. For example a cement factory might be releasing toxic chemicals to a nearby river. Fishers on this river would be influenced from the activities of the factories since chemicals kill the fish. The factory is creating negative externalities on third party fishers (fishers are neither the buyer nor the seller in the cement market).
Or the third parties can get benefits out of production and consumption activities of others; in that case these benefits are called positive externalities. For example an individual who installed a smoke alarm to his house will not only lower the potential damage to his own house due to a fire but also lower the potential damages to his neighbors’ houses. Neighbors who are neither buyer nor the seller of smoke alarms would be positively affected form the smoke alarms. (...)
(...) Lets suppose the per unit health damage of gasoline is also estimated and shown in figure 14.1 as MEC. Now the per unit cost of gasoline to the society would be the sum of per unit marginal cost of gasoline in the markets, MC, (which includes the cost of extraction petroleum, converting it into gasoline, transporting it to gasoline station, advertising it etc…) and per unit health cost of external cost, MEC.
Marginal social cost = Marginal cost (From now on marginal private cost, MPC) + marginal
MSC= MPC + MEC
Efficiency requires the marginal benefit of gasoline to be equal to marginal cost of gasoline (social). So market equilibrium should be at (P’, Q’). However profit maximizing suppliers will keep the prices at P* and utility maximizing drivers will buy Q* units of gasoline. (...)
There will be (Q’-Q*) unit more than efficient amount of production and consumption of gasoline in the market. The yellow triangle (ABC) on figure 14.1 is the deadweight loss (efficiency loss) due to externality. To understand why externalities cause social welfare to go down lets assume initially we are at (P’,Q’) point. When the driver is considering to buy or not to buy one more unit of gasoline she will consider the private cost of buying the gasoline (price) and compare with the benefit of buying it. Obviously at this point marginal benefit of buying one more unit of gasoline is higher than marginal private cost of buying it, so the driver will buy it. However consumption of this last unit of gasoline will also cause external health costs to the others by MEC. So the marginal cost of this last unit to the society will be not MPC but MSC which clearly exceeds MB. Thus efficiency requires the driver not to buy and consume gasoline anymore. However, utility maximizing driver will continue to buy gasoline till his MPC equals to MB. After Q’ each unit of gasoline will reduce social welfare while increasing consumer surplus of the driver.
(...) Consider a beekeeper whose beehives are next to an apple orchard. The bees of the keeper will help the apple trees to pollinate. So the bees by producing honey will create benefits to their owner keeper but also external benefits to the owner of apple orchard owner. The higher the number of bees the more effective the pollination process and higher yield in the apple orchard. Thus the welfare of the orchard owner partially depends on the actions taken by beekeeper. Thus beehives are creating positive externalities to apple orchard. Figure 12.2 represents this situation. The marginal costs of keeping beehives are represented by MC. The benefit of bees (honey) to the keeper is represented by MPB (marginal private benefits). The marginal benefit of bees to the apple
orchard owner is shown by MEB (marginal external benefits). The marginal benefit of bees to the society (MSB) is the sum of marginal benefit to the keeper (MPB) and marginal benefit to the owner (MEB).
Marginal social benefit = Marginal benefit (From now on marginal private benefit, MPB) +
marginal external benefit
MSB= MPC + MEB
Like always efficiency requires the marginal social benefit of bees to be equal to marginal social cost of bees.[주1] Thus efficient (social welfare maximizing) amount of bee should be Q*. However since the keeper cares about her own profit, she would keep the profit maximizing amount of bee which is Q`. However since the orchard owner is also a part of the society her benefit should also be taken into consideration and Q* amount of bee should be had by the keeper. However; without intervention from outside the market dynamics result with Q` unit of beehives and keeper will have only Q` units of beehives. In other words the market will supply too little Q`-Q* unit less than efficient amount. The yellow triangle (ABC) on figure 14.2 is the deadweight loss (efficiency loss) due to this positive externality.
To understand why even positive externalities cause social welfare loss lets assume initially we are at (P’,Q’) point. When the keeper is considering to have or not to have one more unit of beehive she will consider the private cost of getting the beehives (MC) and compare with the benefit of it (MPB, the revenue from selling honey produced in this beehive). Obviously at this point marginal benefit of having one more unit of beehive is lower than marginal private cost of it, so the keeper won’t have this extra beehive. However this last beehive will also cause external benefits to the others (orchard owners) by MEB. So the marginal benefit of this last unit to the society will be not MPB but MSB which clearly exceeds MC. Thus efficiency requires the keeper to have this last beehive and continue having extra beehives until MSB equals MC. After Q’ each unit of beehives will increase social welfare until Q*. Since the keeper will have only Q` without any outside intervention, the social welfare would be lower than its full potential. (...)
(...) Now suppose the government imposes a unit tax to the cement production which is equal to the external cost to the fishermen which is shown by t. With this tax the marginal cost of production will increase for the factory owner, now one unit of cement will require not only regular costs to the raw materials, costs of capital, costs of labor etc. (which is represented by MPC) but also a tax to the government. So the marginal cost of cement would be summation of MPC and t which equals to MSC. In this case profit maximizing factory owner would produce Q* units of cement where the owners marginal cost equals to marginal cost. These type of taxes are sometimes called Pigovian taxes referring to A.C. Pigou. (...)