AQA Specification focus:
‘Such products may be subject to positive and negative externalities in consumption.’
Introduction
Externalities in consumption occur when the actions of consumers impose costs or confer benefits on third parties. These spillover effects can cause markets to misallocate resources.
Understanding Externalities in Consumption
Externalities in consumption arise when the consumption of a good or service affects third parties not directly involved in the transaction. These effects are not reflected in market prices, leading to inefficiencies.
Externality in Consumption: A situation where consuming a good or service generates unintended benefits or costs for individuals or society, outside the direct buyer–seller relationship.
When externalities exist, the private costs or benefits experienced by the consumer differ from the social costs or social benefits borne by society as a whole.
Positive Externalities in Consumption
Positive externalities in consumption occur when the use of a good or service provides wider benefits to third parties. These goods are often under-consumed in free markets because individuals only consider their private benefit, not the additional value created for others.
This diagram depicts a positive consumption externality, showing how the social marginal benefit (SMB) curve lies above the private marginal benefit (PMB) curve. The socially optimal quantity (Q) is greater than the market equilibrium quantity (Qe), indicating under-consumption in the free market. The shaded triangular area represents the welfare loss.* Source
Examples include:
Education: Increases human capital and productivity, benefiting employers and the economy.
Healthcare: Vaccinations reduce the spread of disease, protecting others.
Public transport: Reduces traffic congestion and pollution, improving social welfare.
Positive Externality in Consumption: When the consumption of a good or service generates additional social benefits beyond the private benefit to the consumer.
Because private benefits are less than marginal social benefits (MSB), the market equilibrium leads to under-consumption relative to the socially optimal level.
Negative Externalities in Consumption
Negative externalities in consumption occur when the use of a good imposes costs on third parties. These goods are often over-consumed in free markets because consumers do not bear the full costs of their decisions.
This diagram illustrates a negative consumption externality, where the social marginal benefit (SMB) curve lies below the private marginal benefit (PMB) curve. The socially optimal quantity (Q) is less than the market equilibrium quantity (Qe), indicating over-consumption in the free market. The shaded area represents the welfare loss.* Source
Examples include:
Smoking in public: Harms others through second-hand smoke.
Alcohol abuse: Increases healthcare costs and creates social disruption.
Private car use: Leads to congestion, pollution, and accidents, harming society.
Negative Externality in Consumption: When the consumption of a good or service imposes additional social costs beyond the private cost borne by the consumer.
Here, private benefits are greater than the true marginal social benefits (MSB), so the equilibrium quantity is over-consumed compared to the socially efficient level.
Market Misallocation from Consumption Externalities
Externalities in consumption cause a divergence between private and social outcomes. This leads to market failure, as the free market fails to achieve allocative efficiency.
Key points:
With positive externalities, markets under-provide because individuals ignore wider social benefits.
With negative externalities, markets over-provide because individuals ignore external social costs.
Allocative efficiency requires consumption at the level where marginal social benefit (MSB) = marginal social cost (MSC).
Allocative Efficiency Condition: MSB = MSC
MSB = Marginal Social Benefit (value to society from an extra unit consumed)
MSC = Marginal Social Cost (cost to society from an extra unit consumed)
If MSB > MSC, society would benefit from more consumption.
If MSB < MSC, society would benefit from less consumption.
Linking to Merit and Demerit Goods
Externalities in consumption are closely connected to the concepts of merit goods and demerit goods.
Merit goods (e.g. education, healthcare) often generate positive externalities and are under-consumed without government support.
Demerit goods (e.g. cigarettes, alcohol) often generate negative externalities and are over-consumed without government intervention.
Merit Good: A product that creates positive externalities in consumption and is under-consumed in the free market due to individuals underestimating its benefits.
Demerit Good: A product that creates negative externalities in consumption and is over-consumed in the free market due to individuals underestimating its harms.
This distinction reflects value judgements but is important in explaining why governments intervene in markets.
Government Responses to Consumption Externalities
Because externalities in consumption distort resource allocation, governments often intervene to correct market failure.
Policies for Positive Externalities
Subsidies: Reduce the price of merit goods to encourage consumption.
State provision: Direct supply of services such as education and healthcare.
Information campaigns: Encourage greater use by raising awareness of social benefits.
Policies for Negative Externalities
Indirect taxes: Increase prices of harmful goods, discouraging consumption.
Regulation: Legal restrictions, such as smoking bans.
Behavioural nudges: Using default options or framing to reduce harmful consumption.
These policies aim to align private incentives with social welfare, moving consumption closer to the socially optimal level.
Key Takeaways for Students
Externalities in consumption are crucial in explaining why free markets often misallocate resources.
Positive externalities lead to under-consumption, while negative externalities lead to over-consumption.
The condition for allocative efficiency is MSB = MSC.
Merit and demerit goods are strongly linked to consumption externalities.
Government intervention seeks to correct misallocation through taxation, subsidies, regulation, and provision.
FAQ
Externalities in consumption occur when the act of consuming a good affects third parties not involved in the transaction. Examples include second-hand smoke or the social benefits of education.
Externalities in production arise when the process of producing a good or service impacts third parties. Examples include pollution from a factory or improved technology that benefits society.
Consumers usually focus on private costs and benefits, such as personal enjoyment or expense, while ignoring wider social consequences.
For positive externalities, individuals undervalue the benefit to society, so demand is lower than optimal.
For negative externalities, individuals ignore the harm caused to others, leading to excessive consumption.
Not necessarily. While many goods with externalities align with merit (positive) or demerit (negative), the classification depends on value judgements.
For instance, a product may create spillover effects but not be widely labelled as merit or demerit. Examples include certain digital services that provide knowledge spillovers but aren’t formally treated as merit goods.
Some externalities emerge immediately, such as noise from loud music, while others only appear in the long term, such as health effects of poor diets.
Delayed externalities can be harder to manage since consumers may not connect their choices with distant impacts, worsening the under- or over-consumption problem.
Social attitudes shape whether goods are perceived as harmful or beneficial.
In some societies, alcohol use is tolerated, despite negative externalities.
In others, strong cultural opposition limits consumption, reducing external costs.
Norms therefore influence how significant externalities are and how governments respond through policy.
Practice Questions
Define a negative externality in consumption and provide one real-world example. (2 marks)
1 mark for a correct definition: e.g. "A negative externality in consumption occurs when the consumption of a good imposes costs on third parties not directly involved in the transaction."
1 mark for a suitable example: e.g. smoking in public, alcohol misuse, excessive car use.
Using a diagram, explain why goods that generate positive externalities in consumption are likely to be under-consumed in a free market. (6 marks)
1 mark for drawing a correctly labelled diagram with PMB and SMB curves (private marginal benefit and social marginal benefit).
1 mark for correctly identifying that SMB lies above PMB.
1 mark for showing equilibrium quantity (Qe) and socially optimal quantity (Q*).
1 mark for explaining that individuals only consider private benefits, ignoring wider social benefits.
1 mark for identifying under-consumption relative to the socially optimal level.
1 mark for reference to welfare loss or misallocation of resources.
