The Theory of Externalities [ Biz/ed Virtual Developing Country ]

The Virtual Developing Country is a case study of Zambia. There are a series of field trips available looking at different issues connected with economic development. This trip is the Copper Tour and this page looks at the different types of externalities and how they cause market failure.

Theories

Externalities: a form of market failure

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Externalities are where the consumption or production of a good impacts on people other than the producers or consumers that are participating in the market for that good. They are the side effects borne by third parties. In each case the firms or the individuals will bear some form of cost known as the external cost. There are a number of types of externality. Some are of particular relevance to the copper industry.

  • Producer on producer externalities e.g. a copper smelting firm contributing to acid rain which affects the crops of surrounding farmers
  • Producer on consumer externalities e.g. a copper smelting firm causing air pollution that causes tuberculosis
  • Consumer on consumer externalities e.g. smokers causing smoking relating ailments in non- smokers
  • Consumers on producer externalities e.g. passenger cars causing congestion and slowing business traffic

The above suggest that these externalities are always negative and result in external costs. In addition to negative externalities there are positive externalities i.e. benefits accruing to non-participants in the market place arising from the consumption and production of goods and services. These are the external benefits.

Why do economists consider the impact of these? Economists are always interested in the use of resources. When externalities result in third parties having to use resources in response to the external costs and benefits, such as those residents of Copperbelt who need hospital care or have to take days off work due to pollution related illness, there has been a misallocation of resources. They recognise that the market for the good has not taken into account all of the costs and benefits from production and consumption. This is called market failure.

Supply and demand analysis can be used to consider the effect of such negative externalities. Price can be considered to be a measure of the benefit that a consumer derives from the consumption of a unit of a good or service. This is called the private benefit. Thus the demand curve (showing the price that people are prepared to pay for a good or service) can be referred to as the private benefit curve.

Demand curve - private benefits

The supply curve represents the costs of the factors of production involved in the production of a good or service. Thus the supply curve can be referred to as the private cost curve. In the free market the equilibrium position occurs where the supply equals the demand -where the private costs and private benefits are equal.

Supply curve - private costs

In the diagram below the interaction of the market demand and supply curves result in Q^ being produced and P^ being charged. This occurs where the private cost is equated with the private benefit.

Supply and demand - equilibrium

Let's now consider a good or service where there are external costs due to a negative externality. The production of the good involves private costs and external costs. The full cost to society or social cost would include both. In considering the full cost to society the external costs should be added to the private costs. The diagram below illustrates this where the amount of the external cost is added onto the supply curve. This gives us the social cost curve (MSC) showing the total cost to society of the production of the good.

Negative externalities - external costs

Social costs = Private costs + External costs

The supply and demand curves only take into account the private costs and private benefits and none of the costs or benefits experienced by third parties. The market price and output of P0 and Q0 do not coincide with the level of output and the price that reflects the full cost to society.

The price that should be paid if all the costs of the negative externalities are taken into account would be shown in Fig 2 as P1 and the quantity would be Q1. The market failure in this case is that the free market over-produces and under-prices goods with associated negative externalities.

In the case of the copper industry the world price of copper does not take into account the damage that is being done to those people who are experiencing the effects of environmental pollution. Indeed as the consumers of copper and the producers of copper are located in different countries. Some would argue that as long as the environmental impact of production is restricted to the LDCs the wealthy consumers have little incentive to worry about the negative externalities associated with it.

Next theory - The Problems Associated with Inflation >>


Related Glossary Items:
Externalities
Negative Externalities
Positive Externalities
Market Failure

Related Issues:
The Environmental Impact of the Production of Copper
The Impact of Farming on the Environment
External Costs of Building Kariba Dam
External Benefits of Building Kariba Dam
The Economic Costs of Tourism

Related Theories:
Establishing Property Rights
Market Failure