Externalities

Anything we do, the way we act and the decision we make often affect other people. Usually the transactions we do are made by our own will or meant for our own benefit, however, these may affect others, even if they weren't involved in the transaction, in a negative or positive way.  By economists this is known as

EXTERNALITIES.
"Private costs of behavior are different from the social cost" (Naked Economics)

As we produce or consume things, as individuals or firms, there are always side effects or consequences that come along. Every decision has an impact on the person who makes the decision, private cost, and sometimes on other individuals, external cost. What this means is that an activity (consumption or production), which an individual or firm performs often affect other people without these other people having to do anything in the decision making process.  For example, smokers pay the the price of the cigarettes (by paying the cigarette they pay the materials in it, employees that that to make it and part of the taxes). However, these don't pay for the amount of air pollution they are creating or the health impacts they are generating on people who are around them. This gap between the private cost (smokers paying cigarets) and the social cost (pollution and health threats) of a certain behavior is known as an EXTERNALITY.  

PRIVATE CO$T

EXTERNAL CO$T

However don't get me wrong. All externalities are not not considered bad. There are POSITIVE and NEGATIVE externalities. 

+POSITIVE+
EXTERNALITIES

An individual behavior that can have a positive impact on society and are not fully rewarded or compensated for it. 
(Naked Economics)

✔ Third party benefits

✔ PRICE increases and QUANTITY as well

✔ To generate positive externalities government put laws and taxes

✔ To maintain positive externalities the GOVERNMENT implements subsidies.

-NEGATIVE-
EXTERNALITIES

A decision or activity that imposes a cost on an individual, or many individuals, that haven't been part of that decision. 
(Episode 32: Externalities)

✗ Third party costs

✗ To stop negative externalities the government implements laws and taxes.

✗ When individuals or firms are producing they try to minimize their cost and they don't pay their externalities. Therefore society is affected by the negative externalities. The government doesn't step in because of the lobbyist who make sure that they doesn't interfere with their activities

---

PROBLEM: 
Prices don't capture all of the cost of the transaction;
 instead some of the cost is paid by a third party 
which has nothing to do in the decision.

SOLUTION: 
Adjust price so that it concurs with the total cost. 
INTERNALIZING THE COST → Imposing a tax equal to the 
difference between the private price and social cost. 
To force buyer and seller to pay the FULL COST.

INDIVIDUALS are very greedy and selfish. We are only looking at the price and cost something brings to us and the benefits it gives us. But how about that external cost, the impact it has on society? Why should others pay for your private decision? 

This is known as market failure. Market Failure is the examination of a particular instance in which the free market, private consumers and sellers interact with each other, and equilibrium level of output actually reduces the level of walfre in society.

Is there a PERFECT BALANCE? 
NO. 
However, one of the solutions is to charge the external cost to 
individuals or firms as they make decisions. 

SOCIAL COST= private cost + external cost