Sample Notes (Unit 1 - Competitive Markets)

Unit 1 (previously Unit 2) - Market Failure - Externalities

Externalities (Spillover Effects)

• Externalities arise when private costs/benefits are different from social costs/benefit
• Basically, this occurs when an economic transaction affects a third party, separate from the consumer and the producer
• There are positive and negative externalities

Negative Externalities

Example: A factory producing shoes pollutes the river. The cost of shoe production is paid by the factory, but there is also the cost to the villagers who can no longer the water to wash, fish, bathe and have to source water elsewhere. These villagers are affected by a negative externality.

Private cost (PC) – cost of an activity to an individual economic unit, e.g. consumer/firm

Social cost (SC) – cost of an activity not just to the economic unit which creates the cost, but to the rest of society as well

If SC > PC à there is a negative externality (external cost)

SC = EC + PC

Positive Externalities

E.g. I am infected with H1N1. By seeking early medical treatment and then quarantining myself, I benefit a) myself; but also b) all the other people that I do not infect, as a result of my precautionary action.

Private benefit (PB) – benefit of an activity to an individual economic unit

Social benefit – benefit of an activity not just to the economic unit creating the benefit, but to the rest of society too

If SB > PB à there is a positive externality (external benefit)

SB = EB + PB

Markets do not account for these externalities; they are not included in the prices we pay.

The price mechanism only reflects private costs/benefits.

This is a form of market failure.

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