Externalities

Vishu Bandari
Aug 31, 2018 · 2 min read

in my previous post I have argued that social cost in a transaction is an externality and we discussed about how its pricing should be done and so on..

you can check that post here

So what is an externality ?

if we google it, it shows that it is a consequence of an commercial activity for which the price is not payed. It can be external cost or a benefit.

since some costs are ignored by the decision makers we get overuse.

let me define some terms to get deeper understanding :

private cost : The cost paid by the consumer or the producer.

External Cost : The cost paid by the bystanders, the people other than the consumer or the producer.

Social Cost : it is the cost to everyone, the sum of private cost and external cost.

Externalities : these are the external costs. they are costs or benefits that fall for the bystanders.

Social surplus = consumer surplus + producer surplus + bystanders surplus .when there is an significant external cost, the market will not produce social surplus

In market economy we generally rely on this point (where supply and demand meet) to set a price for the commodity or a service but we ignore the external cost which should be included in order to maintain a sustainable economy.

this shift in market equilibrium is the cause for the overuse.

there is a shift in quantity which is produced in the market

So what steps should we take, when there is an external cost output should be decreased to increase the social surplus or we should introduce taxes which will increase the price and subsequently decreasing the quantity.

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