Externality, MEC and MEB

Statement

An externality is a cost or benefit imposed on third parties by the production or consumption of a good or service, for which no compensation is paid or received. Externalities are also called spillover effects; third parties are agents not directly involved in the production or consumption of the good.

• Marginal External Cost (MEC) — the cost to third parties from the production or consumption of an additional unit of a good or service. With a negative externality, $MSC = MPC + MEC$.
• Marginal External Benefit (MEB) — the benefit to third parties from the production or consumption of an additional unit of a good or service. With a positive externality, $MSB = MPB + MEB$.

Notes

Externalities are unpriced by the free market — they are not reflected in market prices, so producers and consumers ignore them in their private decision-making. This drives a divergence between private and social valuations: the marginal social cost or benefit curve diverges from its private counterpart by the marginal external cost or benefit, and the free-market quantity at $MPC = MPB$ no longer coincides with the social optimum. The resulting over- or under-allocation of resources is analysed for negative externalities and positive externalities. The MEC and MEB are read off a diagram as the vertical distance between the social and private curves at a given quantity.