23115 Chapter Notes - Chapter 10: Social Cost, Demand Curve, Externality
Externalities I
Externality is the uncompensated impact of one person’s actions on the wellbeing of another, being
either positive or negative. An uncompensated impact means the person whose activity generates
an externality does not pay or receive any compensation for that effect. Because buyers and
sellers neglect the external effects of their actions when deciding how much to demand or supply,
the market equilibrium is not efficient in the presence of externalities.
In a free market, the supply curve reflects private costs, and the demand curve reflects private
value, therefore equilibrium is efficient under certain conditions. However, a negative externality
produces a social cost:
Therefore the welfare cost of the externality is area ABC, and this is why the market fails; (A) is the
point of equilibrium with relevance to social cost.
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Document Summary
Externality is the uncompensated impact of one person"s actions on the wellbeing of another, being either positive or negative. An uncompensated impact means the person whose activity generates an externality does not pay or receive any compensation for that effect. Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not ef cient in the presence of externalities. In a free market, the supply curve re ects private costs, and the demand curve re ects private value, therefore equilibrium is ef cient under certain conditions. However, a negative externality produces a social cost: Therefore the welfare cost of the externality is area abc, and this is why the market fails; (a) is the point of equilibrium with relevance to social cost. In order to internalise the externality, government intervention may impose a tax acting as the new supply being the social and private costs:
