Some economic agents have benefits or costs separate from the producers and consumers involved immediately in the transactions. These benefits or costs that accrue to external parties not through a market mechanism are known as externalities, and can have social benefit or cost to the country.
Negative Externality | |
|
Consider a production facility, such as a steel mill, that
has a negative effect on the environment. Under normal conditions, producers produce at the marginal private cost (MPC) and consumers consume at the marginal private benefit (MPB). With no externalities, the optimum position is where these coincide, at Q1. However, the negative effect on the environment is an added cost - the marginal damage to society (MD). Thus the real production cost is MPC+MD. In the context of the whole economy, the optimal production point is Q2. | |
Positive Externality | |
|
On the other hand, if there is positive externality, there
is a similar situation:
|
|
Government Action | |
|
In the previous case, we have seen that the preferred production
point for producers is different from the optimal production point
for the whole economy. So how can the government encourage producers
to shift their production? In free trade, with a world price of P along the line MR, producers produce at A and consumers consume at B. With positive externality, the optimal production point for the society is where MSC=MR, at C. To move production from A to C, the government can subsidise domestic producers not to make a loss by producing up to C. If the government does not know MPC, they might be forced to subsidise as much as HJLN. On the other hand, if the government knows MPC, the optimal subsidy will be JLN, and the net gain to the economy is KLN. |