Externalities
Recall from Chapter 12 that in order for the economy to be allocatively
efficient, marginal benefit (or value) must equal marginal cost for all
products. But whose benefits and costs are relevant? Firms that are
maximizing their own profits are interested only in their own costs of
production—they may not care about any benefits or costs their actions
might create for others. Similarly, insofar as individual consumers are
interested in the benefits they receive from any given product, they ignore
any costs or benefits that may accrue to others. An externality occurs
whenever actions taken by firms or consumers directly impose costs or
confer benefits on others. If you smoke a cigarette in a restaurant, you
impose costs on others present; when you renovate your home, you
confer benefits on your neighbours by improving the general look of the
neighbourhood. Externalities are also called third-party effects because
parties other than the two primary participants in the transaction (the
buyer and the seller) are affected.
The foregoing discussion suggests the importance of the distinction
between private cost and social cost. Private cost measures the cost faced
by the private producer, including production costs, advertising costs, and
so on. Social cost includes the private cost (since the producer is a
member of society) but also includes any other costs imposed on third
parties. There is a similar distinction between private benefit and social
benefit. Private benefit measures the benefits received by the consumer