Skip to main content

Table of Contents

  1. Topic pack - Microeconomics - introduction
  2. 1.1 Competitive Markets: Demand and Supply
  3. 1.1 Competitive Markets: Demand and Supply - notes
  4. 1.1 Competitive markets - questions
  5. 1.1 Competitive markets - simulations and activities
  6. 1.2 Elasticities
  7. 1.2 Elasticities - notes
  8. Section 1.2 Elasticities - questions
  9. Section 1.2 Elasticities - simulations and activities
  10. 1.3 Government intervention
  11. 1.3 Government Intervention - notes
  12. 1.3 Government intervention - questions
  13. 1.3 Government intervention - simulations and activities
  14. 1.4 Market failure
  15. 1.4 Market failure - notes
    1. The meaning of externalities
    2. Types of externalities
    3. How do externalities affect allocative efficiency?
    4. Negative externalities of production
    5. Negative externalities of consumption
    6. The economic theory of traffic congestion
    7. Demerit goods
    8. Government responses - demerit goods
    9. Possible government responses to externalities
    10. Direct government provision
    11. Extension of property rights
    12. Taxes and subsidies
    13. Tradeable pollution rights
    14. Regulation, legislation and direct controls
    15. Positive externalities of production
    16. Positive externalities of consumption
    17. Merit goods
    18. Why might merit goods be underprovided by the market?
    19. Government responses - merit goods
    20. Public goods
    21. Common access resources & sustainability
    22. The tragedy of the Commons
    23. Common access resources in practice
    24. Sustainability
    25. Threats to Sustainability
    26. The threat to sustainability from the use of fossil fuels
    27. The threat to sustainability from poverty
    28. Government responses to threats to sustainability
    29. Cap and Trade Schemes
    30. Promoting Clean Technologies
    31. The 'dirty side' of cleaner technologies
    32. International responses to threats to sustainability
    33. Asymmetric information
    34. Abuse of monopoly power
    35. Inequality
  16. Section 1.4 Market failure - questions
  17. Section 1.4 Market failure - simulations and activities
  18. 1.5 Theory of the firm
  19. 1.5 Theory of the firm - notes (HL only)
  20. Section 1.5 Theory of the firm - questions
  21. Section 1.5 Theory of the firm - simulations and activities
  22. Print View

How do externalities affect allocative efficiency?

chemical_plant01Given the existence of perfect competition, allocative efficiency would automatically occur where price equals marginal cost in all markets, assuming that neither negative nor positive externalities are present.

So, how do externalities affect our condition for efficiency? Let's consider case of a firm which discharges its waste products into a river. Such a firm would be treating the environment as a free resource, and would be imposing a cost on society as a whole, rather than just on the consumers of the good. The price charged to consumers would not therefore, in this instance, reflect the true cost of the product; if the firm were compelled to install equipment which could treat its effluent and render it harmless to the environment, its production costs and prices would rise and consumers would, as a consequence, reduce their demand for the product in question. Resources would then be reallocated to other lines of production.

In this case there is a divergence between private and social cost.

  • The private cost is the internal money cost of production incurred by the firm i.e. costs such as wages, raw materials, heating and lighting that must be paid to carry out production, and which would appear in the firm's accounts.
  • The social cost, on the other hand, is the real cost to society as a whole; it is the private, internal costs plus the value of the negative externalities (external costs).

Similarly, if the firm's production decisions were to generate positive externalities, such as the beneficial effects arising from the provision of employment, then there would be a divergence between private and social benefit.

  • The private benefit is the money value of the benefits accruing internally to the firm from production activity e.g. in the form of sales revenues.
  • The social benefit, on the other hand, is the private benefit plus the value of positive externalities (external benefits).


Social cost

Social cost is the private, internal cost plus the value of negative externalities.


Social benefit

Social benefit is the private, internal benefits plus the value of positive externalities.

Now, the significance of this analysis is that allocative inefficiency will occur if private cost or benefit diverges from social cost or benefit. Where externalities exist the condition for allocative efficiency is that price = social marginal cost = social marginal benefit i.e. the price must equal the true marginal cost of production to society as a whole, rather than just the private marginal cost.

We will now illustrate the above in relation to the firm discharging waste into the river.

Hence externalities cause market failure:

  • when a negative production externality is initiated, the firm will not be made to pay for the cost imposed on others, and will therefore have no market incentive to produce less; from society's standpoint it will therefore overproduce;
  • when a positive externality arises, the firm will lack any incentive to increase its output to the socially desirable level, as it does not receive any payment for the generation of the external benefit; underproduction therefore occurs.