Externalities and Public Good

Topic 6: Externalities and Public Goods

An externality is created when the actions of participants in a private market affect the well being of someone not directly associated with that market.

Consider the market for paper. Paper creates a byproduct in its production called dioxin. Dioxin affects innocent bystanders by causing cancer and birth defects. This is a negative externality in production because the paper firm doesn’t consider this cost to society when making production decisions. Since these negative externalities affect innocent by-standers, the cost to society is greater than the cost to firms.

Price, $ S (Social Cost)

S (Private Cost)

D(Private Value)

QE Q* Quantity of Paper

Consider the market for historic buildings and homes. These buildings and homes create positive externalities in consumption because bystanders value historic homes – their beauty and sense of history. Thus, society’s value of the homes is greater than that to the owners of the buildings.

Price, $

S (Private and Social Cost)

D (Social Value)

D (Private Value)

Q* QE Historic Homes and Buildings

Consider alcohol, which creates a negative externality in consumption where the value to society is less than the value to consumers (because of car wrecks, injuries to others, and violence).

Price, $

S (Private and Social Cost)

t D (Private Value)

D (Social Value)

QE Q*