Externalities Revision Notes

Market surplusWhen looking for the market equilibrium (sometimes called the unregulated market equilibrium), we want to select the quantity where demand = supply or where marginal private benefit = marginal private cost.

Diagrammatically, this will happen where MPB intersects MPC.

The quantity where this occurs will always maximize market surplus.

Social surplusWhen looking for the social surplus maximizing equilibrium, we want to select the quantity where marginal social benefit = marginal social cost

Diagrammatically, this will happen where MSB intersects MSC

The quantity where this occurs will always maximize social surplus.

The difference between market and social surplus

1. Marginal social cost = (marginal private cost) + (marginal external cost)
2. Marginal social benefit = (marginal private benefit) + (marginal external benefit)

i.e. MSB - MPB = MEB

Positive externalities from production

Where the marginal social cost of production is lower than the marginal private cost.

Example: Lower transport costs for local firms following construction of new roads

Negative externalities from production

Where the marginal social cost of production is higher than the marginal private cost

Example: Air, land, river and noise pollution which results from factory emissions

Where there are negative production externalities, there is an external cost to production

This means that marginal social cost is greater than marginal private cost

Therefore the MSC line is higher than the MPC line

Positive externalities from consumption

Where the marginal social benefit of consumption is higher than the marginal private benefit.

Examples: Community-access defibrillators External benefits from museum

Where there are positive consumption externalities, there is an external benefit to consumption

This means that marginal social benefit is greater than marginal private benefit

Therefore the MSB line is higher than the MPB line

Negative externalities from consumption

Where the marginal social benefit of consumption is lower than the marginal private benefit.

The impact on family life / social cohesion of problem gambling or drug addiction