Externalities

What are externalities?
EXTERNALITIES TUTOR2U.NET/ECONOMICS
WHAT ARE EXTERNALITIES?
• Externalities refer to the unintended side effects or

consequences of an economic activity or transaction that
affect third parties who are not directly involved in that
activity or transaction.
• These effects can be either positive or negative and are
typically not reflected in the costs or benefits considered
by the individuals or entities involved in the activity.
Externalities
Externalities are spill-over effects from

production and/or consumption for which no
appropriate compensation is paid to one or
more third parties affected
Externalities
Externalities are spill-over effects from

production and/or consumption for which no
appropriate compensation is paid to one or
more third parties affected
Key Exam Point: Externalities lie outside the initial

market transaction and (without state intervention),
they are not reflected in the market price
WHY ARE EXTERNALITIES INEVITABLE?
• Inter-connectedness of Economic Agents: In a modern economy, individuals,

firms, and governments engage in a wide range of economic activities. These
interactions often have ripple effects that extend beyond the immediate parties
involved. For example, when a factory produces goods, it may emit pollutants into
the environment, affecting neighboring communities.
• Property Rights and Transaction Costs: Property rights are not always well-
defined, and transaction costs can be high, making it difficult to negotiate and
enforce agreements that internalize externalities.
• Public Goods: Public goods, such as clean air often cause positive externalities
because they benefit everyone, whether they contribute to their provision.
Individuals may underinvest in such goods, assuming others will bear the costs.
What are the main
types of externality to
know about, analyse
and evaluate?
WHAT ARE THE MAIN EXTERNALITIES?
• Negative externalities in production

• Negative externalities in consumption
• Positive externalities in production
• Positive externalities in consumption
• Mixed externalities
Negative Negative Positive Positive
Production Consumption Production Consumption
Externalities Externalities Externalities Externalities
Such as factory Such as household Such as Such as
pollution waste and noise reforestation vaccinations to
emissions or and air pollution projects and the protect public
waste from free-sharing of health during a
manufacturing academic pandemic
processes research
HOW DO EXTERNALITIES CAUSE MARKET FAILURE?
• Externalities can cause market failure because they disrupt the

efficient functioning of markets.
• Market failure occurs when the allocation of goods and services in a
free-market economy is not efficient or equitable - leading to
outcomes that are not in the best interest of society.
• This means that externalities lead to a net loss of social welfare
• Externalities can lead to market failures because the prices and
quantities determined by supply and demand in the market do not
account for these external costs or benefits.
What is the difference
between private cost
and external cost?
PRIVATE COST
Private costs are the internal costs

faced by the producer or consumer
directly involved in a transaction.
For example, the private cost of
owning and running a vehicle.
PRIVATE COST EXTERNAL COST
Private costs are the internal costs External costs occur when the activity
faced by the producer or consumer of one agent has a negative effect on
directly involved in a transaction. the wellbeing of a third party. They
For example, the private cost of impose costs on other agents. This
owning and running a vehicle. causes social cost > private cost.
What is the difference
between private
benefit and external
benefit?
PRIVATE BENEFIT
Private benefit is the benefit,

satisfaction or utility that an
individual agent such as a consumer
or a business derives from
producing or consuming something
PRIVATE BENEFIT EXTERNAL BENEFIT
Private benefit is the benefit, Social benefits include private

satisfaction or utility that an benefits but also add in the external
individual agent such as a consumer benefits that might occur from
or a business derives from production and/or consumption
producing or consuming something
Marginal Private Cost (MPC)
Marginal private cost is the internal cost

to a producer or consumer from
supplying or consuming one extra unit of
a good or service.
Marginal Private Benefit (MPB)
Marginal private benefit is the extra

benefit, satisfaction or utility gained by a
consumer or producer through
consuming or producing one extra unit of
a good or service.
How are private,
external and social
costs different?
PRIVATE, EXTERNAL AND SOCIAL COST
Marginal private cost Marginal external cost Marginal social cost

(MPC) (MEC) (MSC)
• The cost to a firm of • Cost to third parties • Total cost to society

producing / supplying (the wider society) arising from
an extra unit of from the production / producing /
output, or the costs consumption of an consuming an extra
to an individual of extra unit of output unit of output.
any economic • MSC = MPC + MEC
action/decision
Social Cost
Social cost = private cost + external cost
How is marginal social
cost expressed?
How is marginal social cost
expressed?
Marginal social cost =
marginal private cost +
marginal external cost
NET SOCIAL COST AND BENEFIT
A government is considering four investment projects. It has the resources to finance
and complete just one of these projects.
New city Airport
motorway New schools extension New hospitals
Private benefits 50 135 130 90

Private costs 120 80 100 65
Positive externalities 90 55 35 120
Negative externalities 60 20 60 45
Net private benefit -70 +55 +30 +25
Net social benefit -40 +90 +5 +100
PROPERTY RIGHTS AND EXTERNALITIES
• Property rights define and allocate ownership, control, and responsibilities

over resources and assets.
• When property rights are well-defined, it is easier to determine who should
bear the costs or enjoy the benefits of that activity.
• Well-defined property rights facilitate bargaining and negotiation between
parties involved in an economic activity
• Property rights can incentivize investment in technologies and practices that
mitigate negative externalities or create positive ones.
• Property rights can help prevent or mitigate the tragedy of the commons,
where shared resources are overused or depleted due to a lack of ownership.
CATEGORISE
You have 60 seconds to categorise these eight items relating

to wind farms into one of four categories
Private Costs External Costs Private Benefits External Benefits
1) Less impact on personal 2) Lower taxpayer 3) Visual pollution for

health than fossil fuels subsidies required in LR some people
4) Fewer harmful gases 6) Cost of land +

5) Labour costs
emitted planning permission
7) Falling property prices 8) Employment created –

in area multiplier effects
CATEGORISE
Private Costs External Costs Private Benefits External Benefits
6) Cost of land + 3) Visual pollution for 1) Less impact on personal 4) Fewer harmful gases
planning permission some people health than fossil fuels emitted
7) Falling property prices 8) Employment created –

5) Labour costs
in area multiplier effects
2) Lower taxpayer
subsidies required in LR
GIVE ME 2…
Examples of negative production

externalities
EXTERNALITIES / MARKETS TUTOR2U.NET/ECONOMICS

GIVE ME 2…
Examples of negative production externalities
1 Farming - UK farming causes over a quarter of cities’ particle

pollution, discharges into rivers
Chemical factories - toxins in the water and soil close to 3M's

2 Antwerp factory found to have caused serious long-term
health problems

NEGATIVE EXTERNALITIES FROM PRODUCTION
Air pollution from factories Pollution from fertilizers Industrial waste
Noise pollution Space junk Methane emissions
NEGATIVE EXTERNALITIES FROM PRODUCTION
Air pollution from factories Pollution from fertilizers Industrial waste
Noise pollution Space junk Methane emissions
GIVE ME 2…
Examples of negative consumption

externalities

GIVE ME 2…
Examples of negative consumption externalities
Plastic waste – such as consumption of ready meals / wet
1 wipes. Greenpeace survey - Plastic packaging disposal tops
100 billion pieces a year
Passive smoking – inhalation of second-hand smoke
2 associated with respiratory infections, such as pneumonia and
bronchitis

NEGATIVE EXTERNALITIES FROM CONSUMPTION
Particulates from Household waste Noise pollution Air pollution from

vehicle pollution from neighbours smokers
Traffic congestion Impact of gambling Litter damaging Spillover costs from

addiction on beaches & rising levels of
families waterways obesity
NEGATIVE EXTERNALITIES FROM CONSUMPTION
Particulates from Household waste Noise pollution Air pollution from

vehicle pollution from neighbours smokers
Traffic congestion Impact of gambling Litter damaging Spillover costs from

addiction on beaches & rising levels of
families waterways obesity
NEGATIVE EXTERNALITIES – WELFARE EFFECTS
External costs from air pollution
• Outdoor pollution is linked to around 40,000 deaths each year in the UK,
and more with indoor pollutants
• Air pollution plays a key role in worsening many chronic conditions such
as cancer, asthma, heart disease, and neurological changes linked to
dementia.
External costs from urban road congestion

• The UK is ranked as 3rd most congested in Europe with drivers spending
an average of 32 hours a year in congestion during peak hours
• Direct and indirect costs of congestion for all drivers totaled £31 billion
in 2016, an average of £968 per driver
External costs from air pollution
• Outdoor pollution is linked to around 40,000 deaths each year in the UK,
and more with indoor pollutants
• Air pollution plays a key role in worsening many chronic conditions such
as cancer, asthma, heart disease, and neurological changes linked to
dementia.
External costs from urban road congestion

• The UK is ranked as 3rd most congested in Europe with drivers spending
an average of 32 hours a year in congestion during peak hours
• Direct and indirect costs of congestion for all drivers totaled £31 billion
in 2016, an average of £968 per driver
Why is the ”marginal output”
important?
When drawing diagrams and carrying
out detailed analysis of externalities,
economists work “at the margin”
which considers the impact of one
more unit of consumption / production
Price and Social Cost Consider the example of a cement manufacturing plant is dispersing
and Benefit dust particles into the air and emitting CO2 into the atmosphere.
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
0 Q1 Output / Quantity
What is the private
optimum level of
output?
What is the private optimum
level of output?
The private optimum level of
output occurs where marginal
private benefit = marginal
private cost. (MPB=MPC)
Price and Social Cost Consider the example of a cement manufacturing plant is dispersing
and Benefit dust particles into the air and emitting CO2 into the atmosphere.
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
How do we show the
effect of negative
externalities from the
producer?
Price and Social Cost Negative production externalities create external costs. This leads to
and Benefit marginal social cost being above marginal private cost.
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Negative production externalities create external costs. This leads to
and Benefit marginal social cost being above marginal private cost.
Marginal social cost (MSC)
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Negative production externalities create a divergence between social
and Benefit and private costs.
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Marginal external cost (MEC) is the vertical distance between MSC
and Benefit and MPC at a given level of output such as Q1
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Marginal external cost (MEC) is the vertical distance between MSC
and Benefit and MPC at a given level of output such as Q1
Marginal external cost (MEC)
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
What is the social
optimum level of
output when there are
negative externalities?
What is the social optimum
level of output when there
are negative externalities?
The social optimum takes
externalities into account – in
this case where MSC = MPB
Price and Social Cost The social optimum output does not ignore the externalities – it is an
and Benefit output where marginal social cost = marginal private benefit

Social optimum
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB) = MSB
0 Q2 Q1 Output / Quantity
Why do we say that
negative externalities
leads to market failure?
Price and Social Cost
and Benefit

Social optimum
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Output Q1 only considers private costs and benefits
and Benefit If we ignore the externalities, output is too high for a social optimum

Social optimum
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Output Q1 only considers private costs and benefits
and Benefit If we ignore the externalities, output is too high for a social optimum

Social optimum
Marginal
private cost
(MPC)
P1
Over
production is a
market failure
Marginal private
benefit (MPB) = MSB
What is the essential
point about negative
externalities and
market failure?
What is the essential point
about negative externalities
and market failure?
The key problem is that often, economic agents do
not take account of the costs their decisions impose
on others. The market fails to price negative
externalities properly leading to misallocation of
resources from a social perspective.
MULTIPLE CHOICE QUESTION (1)
Which of the following represents the additional costs accruing to an

economic agent (an individual or a firm) from the consumption or
production of an extra unit of a good or service?
A. Marginal private costs (MPC)
B. Marginal private benefits (MPB)
C. Marginal social costs (MSC)
D. Marginal social benefits (MSB)
Which of the following represents the additional costs accruing to an

economic agent (an individual or a firm) from the consumption or
production of an extra unit of a good or service?
A. Marginal private costs (MPC)
B. Marginal private benefits (MPB)
C. Marginal social costs (MSC)
D. Marginal social benefits (MSB)
A householder spends £500 to fit a new security system for his house.
This is an example of
A. External costs
B. Private costs
C. External benefits
D. Private benefits
A householder spends £500 to fit a new security system for his house.
This is an example of
A. External costs
B. Private costs
D. Private benefits
The safety that the householder enjoys as a result of his new security
system is an example of
A. External costs
B. Private costs
D. Private benefits
The safety that the householder enjoys as a result of his new security
system is an example of
A. External costs
B. Private costs
D. Private benefits
The extra safety your neighbours might experience because criminals

tend to stay away from neighborhoods that have a lot of burglar alarms
installed is an example of
A. External costs
B. Private costs
D. Private benefits
The extra safety your neighbours might experience because criminals

tend to stay away from neighborhoods that have a lot of burglar alarms
installed is an example of
A. External costs
B. Private costs
D. Private benefits
What is an example of a negative externality?

A. Lower profit due to increased competition from new firms entering
the market.
B. Reduced government funding for a museum.
C. The increase in noise levels from aircraft due to the expansion of a
large city airport.
D. The increase in production costs due to an increase in the cost of
importing raw materials.
What is an example of a negative externality?

A. Lower profit due to increased competition from new firms entering
the market.
B. Reduced government funding for a museum.
C. The increase in noise levels from aircraft due to the expansion of a
large city airport.
D. The increase in production costs due to an increase in the cost of
importing raw materials.
When will an economic activity create an external cost?

A. when its social cost minus its private cost is negative
B. when its social cost minus its private cost is positive
C. when its social cost minus its social benefit is negative
D. when its social cost minus its social benefit is positive
When will an economic activity create an external cost?

A. when its social cost minus its private cost is negative
B. when its social cost minus its private cost is positive
C. when its social cost minus its social benefit is negative
D. when its social cost minus its social benefit is positive
What would not be classified as an externality?

A. The building of a new housing estate increases traffic congestion.
B. The entry of a new firm into an industry reduces the profits of
existing firms.
C. The renovation of older houses increases the attractiveness of
neighbouring houses.
D. A rise in smoking increases the number of working days lost due to
smoking-related illnesses.
What would not be classified as an externality?

A. The building of a new housing estate increases traffic congestion.
B. The entry of a new firm into an industry reduces the profits of
existing firms.
C. The renovation of older houses increases the attractiveness of
neighbouring houses.
D. A rise in smoking increases the number of working days lost due to
smoking-related illnesses.
How can we show the
social welfare loss arising
from negative production
externalities?
Price and Social Cost The social welfare loss arises from over-production given that society
and Benefit would wish to supply Q2, but the private optimum is output Q1
Social optimum
Marginal
private cost
(MPC)
P1
Over
production is a
market failure
Marginal private
benefit (MPB)
Price and Social Cost The social welfare loss arises from over-production given that society
and Benefit would wish to supply Q2, but the private optimum is output Q1
B
A
Social optimum
Marginal
private cost
C
(MPC)
P1
Over
production is a
market failure
Marginal private
benefit (MPB)
Price and Social Cost Beyond output Q2, marginal social cost (MSC) is higher than marginal
and Benefit private benefit (MPB). This causes social welfare to fall.
B
A
Social optimum
Marginal
private cost
C
(MPC)
P1
Over
production is a
market failure
Marginal private
benefit (MPB)
Price and Social Cost The deadweight welfare loss arising from over-production (Q2-Q1) is
and Benefit the the triangle ABC.
B
A Social welfare loss

Social optimum
Marginal
private cost
C
(MPC)
P1
Over
production is a
market failure
Marginal private
benefit (MPB)
How can we analyse
negative externalities
using cost and benefit
curve diagrams?
Benefit, Social optimum is where MSB
Cost = MSC
MPC = MSC
A
MPB
B
MSB
Q1 Q2 Quantity consumed
Benefit, Social optimum is where MSB
Cost = MSC
MPC = MSC
With negative consumption
externalities, if consumption
C of a product reduces benefits
enjoyed by third parties, the
benefits to society are less
A than benefits obtained by
MPB individuals consuming the
product. Negative
externalities lead to
B
overconsumption and hence
MSB overproduction
Benefit, Deadweight loss of social Social optimum is where MSB
Cost welfare = ABC = MSC
MPC = MSC
With negative consumption
externalities, if consumption
C of a product reduces benefits
enjoyed by third parties, the
benefits to society are less
A than benefits obtained by
MPB individuals consuming the
product. Negative
externalities lead to
B
overconsumption and hence
MSB overproduction
What are positive
externalities?
Positive Externalities
Positive externalities exist when third parties

benefit from the spill-over effects of
production/consumption. When there are
positive externalities, social benefits exceed
private benefits.
Social Benefit
Social benefit = private benefit +

external benefit
Marginal Social Benefit (MSB)
Marginal social benefit = marginal private

benefit (MPB) + marginal external benefit
(MEB)
GIVE ME 2…
Examples of positive consumption

externalities

GIVE ME 2…
Examples of positive consumption externalities
1 External benefits from libraries, museums and other freely-

available public spaces
2
Community take-up of vaccines and wearing face masks
during the pandemic

POSITIVE EXTERNALITIES FROM CONSUMPTION
Health care services Wearing a face mask Subsidised Cycle Public libraries /
during a public health Schemes in urban community spaces
crisis areas including parks
Museums and Free school meals / Apple orchards that People taking up the
Galleries open access improved nutritional allow bee populations offer of vaccinations
to the general public advice to grow
How can we analyse
positive externalities
using cost and benefit
curve diagrams?
Price and Social Cost Consider a council increasing their spending on local library services
and Benefit providing books, iPads and other resources to the community
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Improved access to and use of libraries can generate external
and Benefit benefits over time.
Marginal
private cost
(MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost This causes the marginal social benefit of
and Benefit consumption to be higher than the
marginal private benefit. (MSB > MPB)
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost The marginal external benefit is the
and Benefit difference between MSB and MPB
Marginal external
benefit (MEB)
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost In a free market, consumption will be at
and Benefit Q1 because demand = supply (private
benefit = private cost)
Marginal external
benefit (MEB)
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost However, this is socially inefficient
and Benefit because at Q1, social marginal cost <
social marginal benefit.
Marginal external
benefit (MEB)
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost Society would prefer the output to be Q2
and Benefit where we take positive externalities into
account
Marginal external
benefit (MEB)
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost Social efficiency would occur at Q2 where social cost =
and Benefit social benefit. If we stay at Q1, there is under-
consumption, and this is a cause of market failure.
Marginal external
benefit (MEB)
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost Social efficiency would occur at Q2 where social cost =
and Benefit social benefit. If we stay at Q1, there is under-
consumption, and this is a cause of market failure.
Marginal external
benefit (MEB)
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Under
consumption
is a market Marginal private
failure
benefit (MPB)
How can we show the
social welfare loss arising
from positive consumption
externalities?
Price and Social Cost Society would prefer a level of consumption of Q2
and Benefit whereas the free market equilibrium (which ignores
the externalities) is at Q1.
Marginal
private cost
(MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
the externalities) is at Q1.
B Marginal
private cost
(MPC)
P1
C Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
the externalities) is at Q1. The deadweight loss of social
welfare is shown by the area ABC.
B Marginal
private cost
(MPC)
P1
C Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
What interventions might
be used to address the
market failures from
positive externalities?
INTERVENTIONS WITH POSITIVE EXTERNALITIES
1. Government subsidy to the

consumer (reduces their private
cost / increases real income)
Health care Subsidised Cycle Public libraries /
services Schemes in urban community 2. Government subsidy to the
areas spaces including producer
parks
3. Government provision and
funding
4. Behavioural nudges to change
Free school meals Apple orchards People taking up
/ improved that allow bee the offer of consumer behaviour
nutritional advice populations to vaccinations
grow 5. Mandatory choices such as
compulsory education
What are positive
externalities from
production?
POSITIVE EXTERNALITIES FROM PRODUCTION
Open-Source Software made Positive spillover effects from

freely available to other users university research and
development
GIVE ME 2…
Examples of positive production

externalities

GIVE ME 2…
Examples of positive production externalities
1 Spending on infrastructure – reduces delays, lowers costs for

logistics / transportation,
2 Open-Source Software that is made freely available to other

users. Spillovers from research and development projects in
areas such as materials science and vaccine platforms

Price and Social Cost Because there are positive externalities in production,
and Benefit the marginal social cost of production is less than the
marginal private cost of production. (MSC<MPC)
Marginal private cost (MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost Because there are positive externalities in production,
and Benefit the marginal social cost of production is less than the
marginal private cost of production. (MSC<MPC)
P1
Marginal private
benefit (MPB)
Price and Social Cost The socially optimum level of output in this example is
and Benefit therefore higher than the free market equilibrium.
P1
P2
Marginal private
benefit (MPB)
Price and Social Cost Positive production externalities shifts the supply curve
and Benefit to the right. The market failure is because there is
under-production (Q1 is less than Q2).
P1
P2
Marginal private
benefit (MPB)
How do we show the social
welfare loss arising from
this under-production?
Price and Social Cost The social welfare loss is shown by the area ABC
and Benefit
A
P1
C Marginal social cost (MSC)
P2
B
Marginal private
benefit (MPB)
A government is planning to
intervene in a free market to fix
output at the level that maximises
the economic welfare of society.
To achieve its objective, what
should the government introduce?
A a subsidy of TS
B a subsidy of YX
C a tax of TS
D a tax of YX
A government is planning to
intervene in a free market to fix
output at the level that maximises
the economic welfare of society.
To achieve its objective, what
should the government introduce?
A a subsidy of TS
B a subsidy of YX
C a tax of TS
D a tax of YX
In cost-benefit analysis the term net social benefit refers to

A. private benefit plus social benefit.
B. social benefit minus private benefit.
C. social benefit minus private cost.
D. social benefit minus social cost.
In cost-benefit analysis the term net social benefit refers to

A. private benefit plus social benefit.
B. social benefit minus private benefit.
C. social benefit minus private cost.
D. social benefit minus social cost.
The following diagram shows

the market for a good. Which
area represents the welfare
loss which would occur if it was
supplied in a free market
economy?
A. LNP
B. KNPL
C. KLN
D. IJL
The following diagram shows

the market for a good. Which
area represents the welfare
loss which would occur if it was
supplied in a free market
economy?
A. LNP
B. KNPL
C. KLN
D. IJL
What are mixed
externalities?
Mixed Externalities
Mixed externalities occur when production

and/or consumption leads to both external
costs and external benefits. The socially
optimum level of output will depend on the
extent and value of these negative and
positive externalities.
WHAT ARE MIXED EXTERNALITIES?
• Mixed externalities, also known as "partially internalized externalities,"

occur when an economic activity generates both positive and negative
externalities simultaneously.
• In other words, the same activity or transaction has both beneficial and
harmful effects on third parties who are not directly involved.
• Mixed externalities can be more complex to address than cases with
purely positive or negative externalities because policymakers need to
consider both types of effects and find ways to encourage the positive
aspects while mitigating the negative ones.
EXAMPLES OF MIXED EXTERNALITIES (1)
• Consider the use of automobiles in a congested urban area.

• This situation can result in mixed externalities:
• Negative Externality: The increased use of cars in a city leads to traffic
congestion, air pollution, and noise pollution, which negatively affect residents'
quality of life and health.
• Positive Externality: On the positive side, the availability of cars provides
convenience and mobility to individuals, making it easier for them to access
jobs, education, and services. It also contributes to economic activity through
transportation and supports various industries, such as automotive
manufacturing.
EXAMPLES OF MIXED EXTERNALITIES (2)
• Example: Agricultural Pesticide Usage

• In modern agriculture, the use of pesticides to protect crops from pests and diseases
can result in mixed externalities:
• Negative Externality: When farmers use pesticides, there is a risk of environmental
pollution. Pesticides can leach into the soil, contaminating groundwater and nearby
water bodies. Additionally, they can harm non-target organisms like beneficial insects,
birds, and aquatic life.
• Positive Externality: On the positive side, the use of pesticides can lead to increased
agricultural productivity and higher crop yields. This contributes to food security,
lowers food prices, and supports the livelihoods of farmers and agricultural workers.
In turn, it can benefit society by reducing the risk of food shortages and price spikes.
Price and Social Cost In this situation production leads to negative externalities but
and Benefit there are also some positive externalities from consumption
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost Overall, the free-market price is too low, and output is too high
and Benefit – leading to a loss of social welfare
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost Overall, the free-market price is too low, and output is too high
and Benefit – leading to a loss of social welfare
P2 Marginal private cost (MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
Price and Social Cost Here, the extent of external benefits outweighs the external
and Benefit costs so that the social optimum output Q2 is higher than Q1.
P2 Marginal private cost (MPC)
P1
Marginal social
benefit (MSB)
Marginal private
benefit (MPB)
The diagram shows the private and social

costs and benefits of production in a free
market that result in market failure.
Which change in output would be
necessary to overcome this market
failure?
A. From K to M
B. From M to N
C. From M to L
D. From N to L
The diagram shows the private and social

costs and benefits of production in a free
market that result in market failure.
Which change in output would be
necessary to overcome this market
failure?
A. From K to M
B. From M to N
C. From M to L
D. From N to L
The supply and demand curves for a good

in a free market are S1 and D1. If the good
generates negative externalities in
production but positive externalities in
consumption, which intersection, A, B, C
or D, could represent the socially optimal
equilibrium?
A. Intersection A
B. Intersection B
C. Intersection C
D. Intersection D
The supply and demand curves for a good

in a free market are S1 and D1. If the good
generates negative externalities in
production but positive externalities in
consumption, which intersection, A, B, C
or D, could represent the socially optimal
equilibrium?
A. Intersection A
B. Intersection B
C. Intersection C
D. Intersection D
What government
interventions can help to
reduce negative externalities
and therefore correct market
failure?
CARBON TAXES – MAKING THE POLLUTER PAY
Internalising
Make the polluter pay
externalities
A carbon tax is a tax on the consumption or production of goods and services, which cause carbon
emissions. It is a policy designed to make the polluter pay for externalities created.
Price, MPC +
Benefit, MSC tax
Cost
B
MPC
Q1Q2 is MPB= MSB

the over-
production
without a
tax Q1 Q2 Quantity supplied
Market failure
Price, MPC +
Benefit, MSC tax
Cost
B
MPC
Q1Q2 is MPB= MSB

the over-
production
without a
Market failure
Price, MPC + • A tax on carbon increases the
Benefit, MSC tax private cost of emitting
Cost
carbon – in theory this will
B cause output to contract
MPC
towards the social optimum
which is output Q1.
• A carbon tax will raise tax
A revenues that might be used
by the government to fund
C clean energy projects or use as
a rebate to those affected such
as consumers & businesses)
Q1Q2 is MPB= MSB

the over-
production
without a
Market failure
Cost
MPC
which is output Q1.
Tax by the government to fund
revenue C clean energy projects or use as
from a a rebate to those affected such
carbon tax
Q1Q2 is MPB= MSB

the over-
production
without a
Market failure
Cost
MPC
which is output Q1.
Tax by the government to fund
revenue C clean energy projects or use as
from a a rebate to those affected such
carbon tax
Deadweight loss of social welfare

Q1Q2 is MPB= MSB
the over- without a carbon tax is the area
production shown by triangle ABC
without a
Market failure
What is a carbon border tax?
1. A carbon border tax aims to reduce emissions by placing a tariff on imports

from countries with less stringent climate policies.
2. The idea is to level the playing field for domestic companies that are
subject to carbon pricing or other climate regulations by preventing foreign
companies from gaining a competitive advantage through lower costs
3. Requires importers to pay a fee for the carbon emissions embedded in the
products they are exporting
4. The European Union (EU) is developing a carbon border tax mechanism,
which is set to be introduced in 2023.
CARBON BORDER TAX TUTOR2U.NET/ECONOMICS

GIVE ME 3…
Advantages / justifications to Europe
introducing a carbon border tax

GIVE ME 3…
Arguments for a carbon border tax
1 Encourages countries with weaker climate policies to take action to reduce

their carbon emissions
2
Protects domestic industries: Helps to prevent "carbon leakage," which
occurs when companies move production to countries with weaker climate
policies
3 Green tariffs generate revenue for climate action: used to fund climate
action, such as investment in renewable energy and energy efficiency
TUTOR2U.NET/ECONOMICS
CARBON BORDER TAX

GIVE ME 3…
Drawbacks to Europe introducing a carbon
border tax

GIVE ME 3…
Drawbacks from a carbon border tax
1 Could lead to trade disputes if it is seen as a protectionist measure. Will

hamper exports from poorer countries.
2
A carbon border tax would increase the cost of imported goods, which could
lead to higher consumer prices. This will have a regressive impact on low-
income households
Simpler to have a global carbon price, which would be levied on all
3 companies per tonne of CO2 produced as a result of their operations. But
agreement on this is a long way off. TUTOR2U.NET/ECONOMICS
CARBON BORDER TAX

CARBON TRADING – A MARKET IN CARBON PERMITS
Price of
carbon Supply of permits
permits S1
(Euro per
tonne of
Co2)
Euro 20
Demand for
carbon permits
Q2 Q1 Quantity of carbon permits

CARBON TRADING – A MARKET IN CARBON PERMITS
Price of
carbon Supply of permits
permits S2 S1
(Euro per
tonne of
Co2)
Euro 40
Euro 20
Demand for
carbon permits
Q2 Q1 Quantity of carbon permits

Economics of Carbon Trading

60 SECOND CHALLENGE
Have a go at typing a
short explanation of
how carbon trading is
designed to reduce
emissions.
EXTERNALITIES / MARKETS
Explanation of carbon trading
Carbon trading creates a market for carbon permits. Firms

that emit more C02 than they are allowed to can buy credits
from companies that emit less. The supply of permits is
capped and gradually reduced which (ceteris paribus) leads
to a higher price. Consequently, a higher marginal private
cost from production might create an incentive for
businesses to invest money in low-carbon technologies.

Price of
permits You can use
(Euro per Supply of permits
tonne of Co2) S2 S1 supply and
Euro 75 demand analysis
when writing
Euro 60 about carbon
trading – but
remember to
Euro 30
develop the
D2 (2021) diagram – shift at
D1 (2020) least two curves
for higher level
Q2 Q1 Quantity of analysis!
carbon permits

GIVE ME 2…
Downsides / limitations of using
carbon trading as a policy to reduce
emissions

GIVE ME 2…
Downsides / limitations of using carbon trading
Carbon price volatility – this is a barrier to investment
1 because of higher risk. A carbon tax provides more certainty
to businesses affected,
Risk of carbon leakage - occurs when companies move

2 production to countries with lower carbon prices, to avoid
paying for carbon credits

What do we mean by
regulatory intervention
to reduce externalities?
REGULATORY INTERVENTIONS WITH EXTERNALITIES
Smoking bans in public Minimum age laws for Maximum C02 emissions for
places tanning salons / gambling new vehicles
Recycling directives for Banning wet wood for use Fishing quotas to protect
household appliances in indoor wood burners stocks from over-fishing
REGULATORY INTERVENTIONS WITH EXTERNALITIES
The case for regulating activities causing Costs / disadvantages from adding extra
negative externalities regulation of industries
• Regulations act as a spur for business High cost of enforcement /

innovation to cut the level of carbon •
administration of strict laws
emissions
• Regulations may be more effective if • Regulations can lead to unintended
demand is unresponsive to price consequences / this causes
changes government failure
• Regulations can be gradually toughened • The cost of meeting regulations can

each year – this will help stimulate discourage small businesses and lead
investment to less competition in markets
EXTERNALITIES OF RIVER POLLUTION
In a damning report, Parliament’s Environmental Audit Committee

stated that “raw sewage, microplastics and slurry are coursing through
all of England’s rivers, putting health and nature at risk ... agriculture
and water companies are the biggest contributors to this chemical
cocktail”. Agriculture: pollution from intensive farming (such as chicken
farms) is a common way that rivers are being contaminated. Water
companies regularly discharge raw sewage into rivers and fail to
inform the public when this occurs.

GIVE ME 3…
Examples of negative externalities caused by excess
chemicals leaked into rivers from intensive farming
by chicken farms
and raw sewage discharged by water companies.

GIVE ME 3…
Examples of negative externalities caused by excess chemicals leaked into rivers from intensive farming by chicken
farms and raw sewage discharged by water companies.
1 Health: risk of drinking polluted water leading to community

sickness – increased burden on the NHS.
2 Nature: Loss of biodiversity due to algae and chemicals

suffocating fish, plants and insects.
3 Economic impact: Wider cost to tourist businesses, impact on

house prices in areas affected.
GIVE ME 3…
Interventions that might be effective
in curbing the dumping of raw
sewage into UK rivers

GIVE ME 3…
Interventions that might be effective in curbing the dumping of raw sewage into UK
rivers
1
Investing in new sewage infrastructure: This long run policy would involve
building new sewage treatment plants and upgrading storm management
capacity. Who should fund it?
2
Unlimited fines / risk of prosecution for companies and executives for
exceeding limits on how much raw sewage can be discharged into rivers. Do
fines have much impact?
Pollution tax: Making the polluter pay – a tax on measured discharges of
3 sewage – increases the private costs of water companies – internalizes the
externality. Is a tax effective?
A chemical firm produces toxic fumes that

impose costs on society. The diagram shows the
free market equilibrium of the firm’s product at
P1Q1. The government imposes a tax on the
firm of XY.
How would this improve resource allocation?
A. It will internalise the external benefit.
B. It will internalise the external cost.
C. It will internalise the private benefit.
D. It will internalise the private cost.
A chemical firm produces toxic fumes that

impose costs on society. The diagram shows the
free market equilibrium of the firm’s product at
P1Q1. The government imposes a tax on the
firm of XY.
How would this improve resource allocation?
A. It will internalise the external benefit.
B. It will internalise the external cost.
C. It will internalise the private benefit.
D. It will internalise the private cost.
A community relies on a private company to supply

electricity using a coal-fired power station. The
power station causes air pollution which imposes an
external cost shown in the diagram.
The government decides to impose a tax on the
electricity company to correct market failure. What
represents the tax?
A. WX
B. WY
C. XY
D. YZ
A community relies on a private company to supply

electricity using a coal-fired power station. The
power station causes air pollution which imposes an
external cost shown in the diagram.
The government decides to impose a tax on the
electricity company to correct market failure. What
represents the tax?
A. WX
B. WY
C. XY
D. YZ
The table shows a firm that has four

possible methods of production to make
its desired output. Each method has a
different cost and causes a different
amount of pollution.
The government rules that polluting firms
must buy pollution permits that cost $90
each. Each permit allows the firm to emit 1
tonne of pollution. No pollution can be
emitted without a permit. Which method
of production has least total cost?

Calculate the private cost + the cost
The government rules that polluting firms of having to buy the carbon permits
must buy pollution permits that cost $90
each. Each permit allows the firm to emit 1
tonne of pollution. No pollution can be

Calculate the private cost + the cost
The government rules that polluting firms of having to buy the carbon permits
must buy pollution permits that cost $90 A: $320 + (3x$90) = $590
each. Each permit allows the firm to emit 1 B: $380 + (2x$90) = $560
tonne of pollution. No pollution can be C: $480 + (1x$90) = $570
D: $700 + (zero) = $700
When will an economic activity create a net social benefit?

A. when (private benefit + external benefit) – (private cost + external cost) is
negative
B. when (private benefit + external benefit) – (private cost + external cost) is
positive
C. when (private benefit + private cost) – (external benefit + external cost) is
negative
D. when (private benefit + private cost) – (external benefit + external cost) is
positive
When will an economic activity create a net social benefit?

A. when (private benefit + external benefit) – (private cost + external cost) is
negative
B. when (private benefit + external benefit) – (private cost + external cost)
is positive
C. when (private benefit + private cost) – (external benefit + external cost) is
negative
D. when (private benefit + private cost) – (external benefit + external cost) is
positive
Which policy by a government would increase the negative externalities

that result from cigarette smoking?
A. A ban on cigarette advertising
B. A ban on cigarette smoking in public places
C. A ban on substitutes for cigarettes
D. A ban on the sale of cigarettes
Which policy by a government would increase the negative externalities

that result from cigarette smoking?
A. A ban on cigarette advertising
B. A ban on cigarette smoking in public places
C. A ban on substitutes for cigarettes
D. A ban on the sale of cigarettes
A government embarks on an anti-smoking campaign.

In a social cost-benefit study, what would be taken into account in an
assessment of the net social benefit of the campaign?
A. Higher government expenditure on pensions due to increased longevity
B. The decline in profits of tobacco manufacturers
C. The financial cost of the campaign to the government
D. The loss in government tax revenue from tobacco duty
A government embarks on an anti-smoking campaign.

In a social cost-benefit study, what would be taken into account in an
assessment of the net social benefit of the campaign?
A. Higher government expenditure on pensions due to increased
longevity
B. The decline in profits of tobacco manufacturers
C. The financial cost of the campaign to the government
D. The loss in government tax revenue from tobacco duty
In India, environmental laws mean chemicals must be disposed of at

specialist waste management centres. To avoid the costs associated with
legal disposal, some firms have dumped chemicals in lakes and rivers.
Such illegal dumping of chemicals is an example of
A. positive externalities
B. the free rider problem
C. a net social welfare gain
D. private costs
In India, environmental laws mean chemicals must be disposed of at

specialist waste management centres. To avoid the costs associated with
legal disposal, some firms have dumped chemicals in lakes and rivers.
Such illegal dumping of chemicals is an example of
A. positive externalities
B. the free rider problem
C. a net social welfare gain
D. private costs
In an economy, competitive firms supply electricity that is generated using

coal-fired power stations. If the government tries to reduce pollution by
imposing an indirect tax on the firms, this would
A. shift the market demand curve to the left.
B. shift the market demand curve to the right.
C. shift the market supply curve to the left.
D. shift the market supply curve to the right.
In an economy, competitive firms supply electricity that is generated using

coal-fired power stations. If the government tries to reduce pollution by
imposing an indirect tax on the firms, this would
A. shift the market demand curve to the left.
B. shift the market demand curve to the right.
C. shift the market supply curve to the left.
D. shift the market supply curve to the right.
One way to allocate road space in a congested city would be to charge

drivers to use the roads. One reason why this policy is likely to result in a
more efficient allocation of resources is because
A. incentives to build new roads would be higher.
B. only higher income drivers would choose to use the roads.
C. road use would be rationed to drivers who benefit from it the most.
D. the government would raise a large amount of revenue from drivers.
One way to allocate road space in a congested city would be to charge

drivers to use the roads. One reason why this policy is likely to result in a
more efficient allocation of resources is because
A. incentives to build new roads would be higher.
B. only higher income drivers would choose to use the roads.
C. road use would be rationed to drivers who benefit from it the most.
D. the government would raise a large amount of revenue from drivers.

Externalities

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Externalities

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What are externalities?

• Externalities refer to the unintended side effects or

Externalities are spill-over effects from

Externalities are spill-over effects from

Key Exam Point: Externalities lie outside the initial

• Inter-connectedness of Economic Agents: In a modern economy, individuals,

• Negative externalities in production

• Externalities can cause market failure because they disrupt the

Private costs are the internal costs

Private benefit is the benefit,

Private benefit is the benefit, Social benefits include private

Marginal private cost is the internal cost

Marginal private benefit is the extra

Marginal private cost Marginal external cost Marginal social cost

• The cost to a firm of • Cost to third parties • Total cost to society

Social cost = private cost + external cost

Private benefits 50 135 130 90

Net private benefit -70 +55 +30 +25

Net social benefit -40 +90 +5 +100

• Property rights define and allocate ownership, control, and responsibilities

You have 60 seconds to categorise these eight items relating

Private Costs External Costs Private Benefits External Benefits

1) Less impact on personal 2) Lower taxpayer 3) Visual pollution for

4) Fewer harmful gases 6) Cost of land +

7) Falling property prices 8) Employment created –

7) Falling property prices 8) Employment created –

Examples of negative production

EXTERNALITIES / MARKETS TUTOR2U.NET/ECONOMICS

1 Farming - UK farming causes over a quarter of cities’ particle

Chemical factories - toxins in the water and soil close to 3M's

EXTERNALITIES / MARKETS TUTOR2U.NET/ECONOMICS

Air pollution from factories Pollution from fertilizers Industrial waste

Noise pollution Space junk Methane emissions

Air pollution from factories Pollution from fertilizers Industrial waste

Noise pollution Space junk Methane emissions

Examples of negative consumption

EXTERNALITIES / MARKETS TUTOR2U.NET/ECONOMICS

EXTERNALITIES / MARKETS TUTOR2U.NET/ECONOMICS

Particulates from Household waste Noise pollution Air pollution from

Traffic congestion Impact of gambling Litter damaging Spillover costs from

Particulates from Household waste Noise pollution Air pollution from

Traffic congestion Impact of gambling Litter damaging Spillover costs from

External costs from urban road congestion

External costs from urban road congestion

Marginal social cost (MSC)

Marginal social cost (MSC)

Marginal social cost (MSC)

Marginal social cost (MSC)

Marginal external cost (MEC)

Marginal social cost (MSC)

Marginal external cost (MEC)

Marginal social cost (MSC)

Marginal external cost (MEC)

Marginal social cost (MSC)

Marginal external cost (MEC)

Marginal social cost (MSC)

Marginal external cost (MEC)

Which of the following represents the additional costs accruing to an

Which of the following represents the additional costs accruing to an

The extra safety your neighbours might experience because criminals

The extra safety your neighbours might experience because criminals

What is an example of a negative externality?

What is an example of a negative externality?

When will an economic activity create an external cost?