Course

Externalities

Instructor: Alex Tabarrok, George Mason University

Externalities : Costs or benefits to third parties that are not involved in the given economic activity. This is from the video “ An Introduction to Externalities

Externalities: Costs or benefits to third parties that are not involved in the given economic activity. This is from the video “An Introduction to Externalities” in the Principles of Microeconomics course.

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Transcript

Okay, well, with that as an introduction, let's define some terms. Private cost: this is the cost paid by the consumer or the producer. External cost: this is a cost paid by bystanders, by people other than the consumer or the producer. It's a cost paid by people other than those who are buying or selling in this particular market. The social cost is the cost to everyone - the cost when we take into account consumers, producers, and bystanders. In other words, it's the private cost plus the external cost.


Externalities: this is simply, another word for external costs or external benefits. We'll talk more about external benefits in a future talk. In other words, externalities is just another word for costs or benefits that fall on bystanders. When there are significant external costs or external benefits, a market will not maximize social surplus. Now, remember we showed earlier that a market maximizes consumer surplus plus producer surplus. That's always true for a free market. However, what we've just learned is that an external cost is a cost that falls on bystanders, not on consumers or producers.


So social surplus, which is consumer surplus plus producer surplus plus bystander surplus, that's ultimately, really what we care about. We care about not just about consumers and producers, we care about everyone including bystanders. So, we want to maximize social surplus. However, when there are significant external costs or benefits, the market is not going to maximize social surplus. It's going to maximize consumer surplus plus producer surplus. But that's not everything. When the costs and the benefits to bystanders are not counted, then we're not going to maximize social surplus. In fact, we can say things a little bit more precisely, and we'll do that next with a supply and demand diagram.

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