Saturday, April 26, 2014

Externalities and Curve Shifting

Danny wrote:

Hi Professor Arvan,

Can externalities be either on the production or consumption side? That is, for example, a negative externality, does it matter whether you shift the supply curve leftward/inward or the demand curve leftward/inward?

For example, when dealing with a good such as for example, a cologne that is extremely repugnant, is the negative externality related to the consumption or production of the good?

It could be argued from both perspectives, right?

Hence how would you know which curve to shift in order to find the socially optimal quantity? (If you shift either, they do however end up at the same socially optimal quantity, however the prices differ (if you shift the supply curve inward, the new equilibrium would be higher, and if you shift the demand curve inward, price would be lower)

I would appreciate your comments on this.

Thank you.


My response:

There can certainly be externalities in consumption and they can be either positive or negative.  For example, sometimes there is a desire to be "part of the crowd."  If many students wear bluejeans to class, other students might want to wear them for that reason.  This is a positive consumption externality that is sometimes referred to as a network effect.  Advertisers understand this and one economic rationale for advertisement of a certain sort is to encourage the market to congeal on that product.

I didn't quite get the example with the cologne.  Presumably a person wears a scent to attract others.  If the cologne were generally repugnant, that would seem to be a product without a market.  But one might consider a scent that most others like yet that a few are allergic to.  There would be a negative externality in that case in causing the allergic reaction.

One can a little nitpicking on products that are durable by separating out purchase from use.  The bluejeans mentioned about don't contribute to the network effect if they hang in the person's closet.  The networks effect only arises when the person is seen wearing them.  Something similar can be said for the cologne.  Normally we are not so finicky in making our analysis and assume purchase and use are strongly correlated.

The last point I'd make is to be careful about discussing curve shifting in the presence of the externality.  In the textbook case of a factory that is polluting the air as a byproduct when operating the plant, neither the supply curve nor the demand curve shift as a consequence of the externality.   Normally we analyze this case by saying the marginal social cost shifts inward (from the original supply curve) where social cost includes both the production costs and the abatement costs.   In contrast, in the presence of network effects the demand curve itself actually shifts.


  1. Ok great, that makes sense.

    One further question, may I ask why is it however that a positive externality, is a result (or cause?) of underproduction whereas a negative externality is a result (or cause?) of overproduction? Are 'underproduction' and 'overproduction' the correct economical nomenclature to describe why the marginal social benefit (or cost) differs from the marginal private benefit (or cost)? And why is it called this way? Am I correct in thinking it is because producers are producing too much of something because they don't internalise or take into account the externality (i.e. cigarettes)? I guess for a consumption related externality the terms 'overconsumption' and 'underconsumption' would be used instead?

  2. For some types of externalities, the use of the terms over production and under production make sense. Pollution is a good example of that. At present we have over production of coal as an energy source and under production of clean alternative (solar and wind).

    In the getting on the network sort of externality, the issue isn't over production or under production. In the light beer market, for example, Miller Brewing's product and Budweiser's product may be near perfect substitutes, judged by taste tests and the production process. But consumers might find one "cooler" than the other, because of the TV ads, or because of what their friends prefer (this is the externality), or because people they dislike drink the other product (this is also the externality, but in negative form). Over production or under production doesn't apply to this case.