Externalities (Positive and Negative)

When making decisions, individuals and firms consider only those costs (and benefits) that it will directly bear. An activity will be considered worthwhile if the marginal benefit derived from the activity exceeds the marginal cost. However, for some activities, individuals or firms not directly involved in the activities receive benefits or bear costs related to those activities. These indirect benefits are called positive externalities, and these indirect costs are called negative externalities.

Example of a positive externality: Your neighbor decides to landscape their yard, and the resulting pleasant view increases your property values. Example of a negative externality: In manufacturing its products, a factory pollutes a river, reducing the number of fish and therefore the income of fishermen who also use the river. In neither case does the decision-maker have any incentive to take into account the benefits or costs accruing to others.

The requirement for economic efficiency is that MU_A/MC_A = MU_B/MC_B = MU_C/MC_C = etc. However, the values required for economic efficiency in both the short and long run are the societal MC and MR, which might not be the same as the individual MC and MR used in the decision-making process. As a result, economic efficiency suffers if either positive or negative externalities exist. If a positive externality exists, then the value of MU used in the decision-making process will understate societal MU, so societal MU/MC will not equal societal MU/MC for other goods and therefore economic efficiency will not prevail. Similarly, negative externalities result in an understatement of MC in the decision-making process, and again lead to an MU/MC ratio not equal to the comparable ratio for other goods and therefore to economic inefficiency.

If the entity that generates external costs or benefits, and the bearers of those costs and benefits, were to merge into a single firm, then there would be no problem because the firm’s decision-making would take all the costs and benefits into account. If all externalities are internalized, then the MU/MC ratio used in the firm’s decision-making process is the same as the societal MU/MC.