The meaning of externalitiesSyllabus: Explain the concepts of marginal private benefits (MPB), marginal social benefits (MSB), marginal private costs (MPC) and marginal social costs (MSC).
Externalities are costs (negative externalities) or benefits
(positive externalities), which are not reflected in free market
prices. Externalities are sometimes referred to as 'by-products',
'spillover effects', 'neighbourhood effects' 'third-party effects' or
In a given market there are producers
(first parties) and consumers
(second parties) but their actions in making transactions sometimes
affect others (third parties). The main point about this is that
generally producers make decisions on how much to produce based on
their own benefits (Profits usually) and consumers make decisions on
how much to consume based on the benefit to themselves only. Neither
party taking into account their effects on others (third parties). Therefore the
market equilibrium (and consequent allocation of resources) is not
equal to what society as a whole would want it to be (ie maximising
community surplus) in other words the market equilibrium is not at the social optimum.
Free Market economists such as Milton Friedman and the Austrian School have argued that externalities particularly arise because of the absence of markets - as no markets exist for such things as clean air and seas, beautiful views or tranquillity, economic agents are not obliged to take them into account when formulating their production and consumption decisions, which are based on private costs and benefits i.e. those which are internal to themselves.
Another way of putting this is to say individuals have no private property rights over such resources as the air, sea and rivers, and thus ignore them in making their production and consumption decisions.
Property rights refer to those laws and rules that establish rights relating to:
- ownership of property;
- access to property;
- protection of property ownership;
- the transfer of property.
Thus a firm may feel free to dump
effluent into a river as the spoiling of the environment and the
killing of fish is not a cost that it would directly have to bear
(think Sao Paulo´s Rio Teite). Similarly for consumption
externalities like smoking.
The solution therefore is to sell property
rights to interested parties so they have an incentive to look after
the `property´they own - Or sell the right to pollute and the fee could
cover the cleaning up or the solution to the problem etc.
Those on the political left (Interventionists) such as Paul Krugman would be more likely to argue that such an externality would arise because the market system is not regulated and therefore there is a role for government to intrevene to solve problems caused by market failure and to ensure the optimal allocation of resources.
To analyse market failure due to externalities you need to be clear about these concepts:
Marginal - means extra (actually you need two extras to define anything that is marginal
Benefit - Something perceived as a good or helpful result or effect
Private Benefits - Benefits to producers and consumers
External benefits - Benefits to anyone not defined as a consumer or producer
Social Benefits -the sum of private and external benefits
Therefore Marginal Private Benefits (MPB) are the extra benefits from producing (profits) and/or consuming (utility) one extra unit of a good or service.
Marginal Social Benefits (MSB) are the extra private benefits plus extra external benefits from producing (profits) and/or consuming (utility) one extra unit of a good or service.
Marginal Private Costs (MPC) - are the extra private costs from producing (eg wages) and/or consuming (disutility or neg benefit) one extra unit of a good or service.
Marginal Social Costs(MSC) - are the extra private costs plus extra external costs from producing and/or consuming one extra unit of a good or service.