What is an externality — costs and benefits beyond the market — Economics

Before this

This leads to

Who pays for the smoke?

A factory beside a river makes paint. It buys raw materials, pays its workers and sells the paint. Buyers pay the price and take the paint home. Both sides agreed to the deal, and both gained from it. The market seems to have worked.

But the factory also lets waste flow into the river. Downstream, a town takes its water from that river and must pay to clean it, and families who fish there catch less. Those people did not buy any paint and did not agree to anything. Yet they pay part of the cost of every tin. Nothing in the price of paint tells the factory, or its buyers, about that cost.

Economists call this an externality. Every lecture so far has assumed that the buyer and the seller between them feel all the costs and benefits of a trade. This lecture drops that assumption, and it opens the unit on market failure: cases where a free market, left alone, produces the wrong amount of something.

Effects on people outside the deal

Externality

An externality is a cost or a benefit that a trade passes on to third parties: people who are not the buyer or the seller, and who are not paid or charged for it through the price.

A negative externality is an external cost. A positive externality is an external benefit.

Externalities can come from making a good or from using it. A factory's smoke is an externality of production. A neighbour's loud music at midnight is an externality of consumption. Both can be positive too. A beekeeper's bees pollinate the apple trees of the farm next door, which is a benefit of production. A person who gets a flu vaccine is less likely to catch flu and so less likely to pass it on, which is a benefit of consumption to the people around them.

Stop and think

A smoker damages their own lungs. Is that a negative externality?

Show the answer

No. The person who decided to smoke is the person who bears that cost, so it is a private cost, however serious it is. An externality falls on someone outside the decision. Second-hand smoke is the externality: people nearby breathe it without choosing to. The test is not "is this harmful?" but "who bears it, and did they agree to it through the price?"

Private and social: four new names

To put externalities on a diagram, economists split each cost and benefit into a private part and a social part. Each name starts with "marginal", which means "for one more unit".

Marginal private cost (MPC): the cost of one more unit to the seller who makes it. The supply curve shows MPC.
Marginal social cost (MSC): the cost of one more unit to everyone in society. MSC = MPC + external cost.
Marginal private benefit (MPB): the benefit of one more unit to the buyer who uses it. The demand curve shows MPB.
Marginal social benefit (MSB): the benefit of one more unit to everyone. MSB = MPB + external benefit.

The market only "sees" the private parts. Buyers keep buying while MPB is above the price, and sellers keep selling while the price is above MPC. So the market settles where MPC = MPB, at the equilibrium quantity $Q^{*}$ . Society, though, would choose the quantity where MSC = MSB. This lecture calls that the socially optimal quantity, $Q_{opt}$ . When there is no externality, the private and social curves are the same, and $Q^{*} = Q_{opt}$ . That is why the welfare diagrams in earlier lectures could treat the market quantity as the best one.

A negative externality, with numbers

Here is a market with a pollution problem. Marginal private benefit (demand) is $P = 30 - 0.2 Q$ , and marginal private cost (supply) is $P = 6 + 0.1 Q$ . Each unit also does $6 of damage to people downstream.

The market sets MPB = MPC:

30 - 0.2 Q 24 Q^{*} = 6 + 0.1 Q = 0.3 Q = 80

The price is $30 - 0.2 \times 80 = $14$ . Now add the external cost. MSC is MPC plus $6, so $P = 12 + 0.1 Q$ . Society's best quantity sets MSC = MPB:

30 - 0.2 Q 18 Q_{opt} = 12 + 0.1 Q = 0.3 Q = 60

A negative externality of $6 per unit. The market produces Q* = 80, where MPC meets MPB. Counting the damage downstream, MSC lies $6 above MPC, and the best quantity is Q_opt = 60. Every unit from 60 to 80 costs society more than it is worth. The grey triangle, ½ × 20 × 6 = $60 a week, is the deadweight loss.

So the market makes 80 units when 60 would be best. It overproduces by 20 units. Why are those 20 units a problem? Take the 80th unit. A buyer values it at $14. It costs the factory $14 to make, plus $6 of damage downstream, so it costs society $20. Making it wastes $6. For the 61st unit, the waste is almost zero. Add up the waste on all 20 units and you get the grey triangle: $\frac{1}{2} \times 20 \times 6 = $60$ a week. That is the deadweight loss of the externality.

Notice what the answer is not. It is not zero units. The paint is genuinely useful, and the first 60 units are worth more to society than they cost, even counting the damage. The problem is too much, not any at all.

A positive externality

Now turn the picture round. Suppose each unit brings a benefit of $6 to people outside the market, as a vaccination does for the people around the person vaccinated. Then MSB lies $6 above MPB, and society's best quantity is where MSB meets MPC. In the same market, that is 100 units, but the market still makes 80. Buyers ignore the benefit to others, so the market underproduces. The deadweight loss is again a triangle, this time the value lost from the 20 units that are never made. The subsidies lecture ended with exactly this case: it found that the best subsidy equals the external benefit per unit.

Explore both cases below.

Graph builder — external costs and benefits

MPB is P = 30 − 0.2Q and MPC is P = 6 + 0.1Q, so the market makes 80 units. Choose an external cost or an external benefit, and its size per unit. Watch the social curve, the best quantity and the deadweight loss.

Size per unit: $6

The market always makes Q* = 80. The best quantity and the deadweight loss for some externalities (per week):

Externality	Q_opt	The market	DWL
$3 cost	70	too much by 10	$15
$6 cost	60	too much by 20	$60
$3 benefit	90	too little by 10	$15
$6 benefit	100	too little by 20	$60

Notice the symmetry. An external cost and an external benefit of the same size give the same deadweight loss, one by overproducing and one by underproducing. In both cases the price sends the wrong signal, because it carries only the private costs and benefits.

Can the people involved sort it out?

If the factory and the town downstream could simply talk, might they fix the problem themselves? The economist Ronald Coase argued in 1960, in a paper called "The Problem of Social Cost", that they sometimes can. If the costs of reaching and enforcing a deal are low, the two sides can bargain their way to the efficient amount of pollution, whichever of them the law favours. Coase was awarded the Nobel Prize in economics in 1991, partly for this idea.

The catch is in "if the costs are low". One factory and one laundry next door can negotiate. Millions of people breathing a city's air cannot: they cannot all meet, agree and share the bill. That is why most externalities that matter, such as air pollution, need something more than a private deal.

A real case: London's smog and the Clean Air Act

Worked Example — A city's coal smoke (United Kingdom, 1952–1956)

The externality. In the early 1950s, London homes and industry burned large amounts of coal. Each household that lit a coal fire paid for its coal and enjoyed the warmth. The smoke was a cost to everyone else, and nobody paid it through the price of coal. From 5 to 9 December 1952, cold, still weather trapped the smoke over the city. The Royal Meteorological Society reports that about 4,000 deaths were put down to the smog at the time, and that more recent estimates suggest up to 12,000.

The policy. Parliament passed the Clean Air Act 1956. It allowed local councils to declare smoke control areas, where burning smoky fuel was banned, and it offered grants to help households convert their fireplaces to cleaner fuels. In this lecture's language, it forced the private cost of smoky fuel up towards its social cost, partly by rule and partly by helping people switch.

The prediction. If the Act worked as intended, smoke would fall, and with it the external cost that each coal fire placed on others.

What happened. A report by the Greater London Authority (2022) says that concentrations of smoke and sulphur dioxide fell dramatically from the mid-1960s onwards. It credits cleaner fuels such as gas, the closing and moving of London's power stations, and the decline of heavy industry, alongside the Clean Air Acts.

The verdict. The smoke externality was real and enormous, and it shrank. But the Act was one cause among several, so the evidence does not let us say how much of the fall was due to the law alone. The story also has a modern ending. The same report says that all areas of London still exceed the World Health Organization's newer guidelines for fine particles and nitrogen dioxide. The externality changed form, from coal smoke to traffic fumes, rather than disappearing.

Now sort some everyday situations.

Sorter — externality or not?

Put each situation in a box. Ask: does the effect fall on someone outside the deal, who is not paid or charged for it?

Nine situations sorted, each with its reason.

Negative externality: a factory's waste in a river used by a town downstream; loud music from a party at 2 a.m.; second-hand smoke at a bus stop.
Positive externality: a beekeeper's bees pollinating a nearby orchard; a flu vaccination; a firm trains workers who later move to other firms.
Not an externality: a smoker's own lung damage; a driver paying for petrol; a fall in the price of a phone after a new model arrives.

Three classic mistakes

Trap 1 — Calling every harm an externality

A cost is external only if it falls on someone outside the decision who is not compensated through the price. A smoker's own illness is a private cost. The smoke breathed by others is the externality.

Trap 2 — "A negative externality means the good should be banned"

In the example, the best quantity is 60, not 0. The first 60 units are worth more than their full social cost. The market failure is producing too much, not producing at all.

Trap 3 — Mixing up the directions

A negative externality means MSC is above MPC, so the market makes too much. A positive externality means MSB is above MPB, so the market makes too little. Draw the social curve first, then find where it meets the other curve.

Try it yourself

Questions 1 and 2 use MPB: P = 30 − 0.2Q and MPC: P = 6 + 0.1Q, so Q* = 80.

Each unit causes $3 of external cost. Find $Q_{opt}$ , the overproduction and the deadweight loss.

Hint 1
MSC is $P = 9 + 0.1 Q$ .

Hint 2
Set $30 - 0.2 Q = 9 + 0.1 Q$ .

Full answer
$21 = 0.3 Q$ , so $Q_{opt} = 70$ . The market overproduces by $80 - 70 = 10$ units. Deadweight loss $= \frac{1}{2} \times 10 \times 3 = $15$ a week. Halving the external cost from $6 to $3 cut the loss from $60 to $15, a quarter.
Instead, each unit brings $6 of external benefit. Find $Q_{opt}$ and say whether the market makes too much or too little.

Hint 1
MSB is $P = 36 - 0.2 Q$ .

Hint 2
Set MSB equal to MPC: $36 - 0.2 Q = 6 + 0.1 Q$ .

Full answer
$30 = 0.3 Q$ , so $Q_{opt} = 100$ . The market makes 80, so it underproduces by 20 units, with a deadweight loss of $\frac{1}{2} \times 20 \times 6 = $60$ a week.
Classify each as a negative or positive externality of production or of consumption. (a) A farmer's pesticide drifts onto a neighbour's crops. (b) A homeowner restores the front of an old building on a busy street. (c) A motorbike is ridden noisily through a town at night. (d) A company's research is copied freely by other firms.

Hint 1
Ask who made the decision: a producer making something, or a consumer using something?

Hint 2
Then ask whether the people outside gain or lose.

Full answer
(a) Negative, production. (b) Positive, consumption: passers-by enjoy the street. (c) Negative, consumption. (d) Positive, production: other firms gain knowledge they did not pay for.
A factory's smoke dirties the washing at the laundry next door, costing the laundry $500 a week. A filter on the factory chimney would stop the smoke and costs $300 a week. What happens (a) if the law gives the laundry the right to clean air, and (b) if the law lets the factory pollute? Why does this reasoning not solve London's smog?

Hint 1
In (a), the factory must stop the smoke or pay the laundry. Which is cheaper?

Hint 2
In (b), how much would the laundry be willing to pay the factory to fit the filter?

Full answer
(a) The factory fits the $300 filter, because it is cheaper than paying the laundry $500. (b) The laundry would pay anything up to $500 to avoid its loss, so it can pay the factory at least $300 to fit the filter, and both are better off. Either way, the filter is fitted: this is Coase's point. What the law changes is who pays. It does not solve London's smog because millions of people were affected by thousands of chimneys. They could not all meet, agree and share the bill, so the cost of bargaining was far too high.

The bigger idea

Prices are a remarkable signal: they tell buyers and sellers about costs and benefits they could never see directly. But they can only carry costs and benefits that someone pays or receives. An externality is a cost or benefit with no price attached, so the market cannot see it. This is not a sign that markets are useless. It is a precise statement of where they need help.

The fixes all try to attach the missing price, to internalise the externality, so that private cost matches social cost, or private benefit matches social benefit. The next two lectures look at the tools in detail: taxes and regulation for negative externalities, and subsidies and provision for positive ones.

Key concepts in this lesson

An externality is a cost or benefit of a trade that falls on third parties and is not charged or paid through the price.
MSC = MPC + external cost; MSB = MPB + external benefit.
The market produces Q*, where MPC = MPB; society's best quantity, Q_opt, is where MSC = MSB.
A negative externality leads to overproduction and a positive one to underproduction; either way there is a deadweight loss.
Bargaining can fix an externality when few people are involved and deals are cheap (Coase); with many people, other tools are needed.