'We know best what's good for the people.' - from the Central Planning Bible
Lately several readers have been discussing the whys and wherefores of (economic) externalities. It’s a slippery concept to apply as may be deduced from its definition.
An externality is “a consequence of an economic activity that is experienced by unrelated third parties. An externality can be either positive or negative.” - Investopedia.
If a producer (Agent A1) provides a quantity (Q1) of goods/services to a customer (Agent A2) willing to pay price P1 for them, then we have the costs of production and price driven demand represented by the classical producer-demand curves showing the market realities arrived at by A1 and A2 – that is, Q1 exchanged for $P1. In this situation each agent has satisfied his own utility for money and goods.
Now enters agent A3 who is neither a producer nor consumer, and he determines that there are people out there negatively impacted by such production/consumption transactions. By fiat A3 (usually the government) has the power to assess, attribute, and allocate what it determines is the ‘social cost’ of such unhampered transactions. It attributes such a cost to a given industry (economic activity) and, in its wisdom, allocates a portion MEC (marginal external cost) to A1 - as a tax, tariff, license fee, imposed purchase of, say, carbon credits, etc – that A3 claims is a negative externality. But in reality A1 experiences MEC as an added cost of production to his existing MPC (marginal private cost) of production. This yields a new MSC (marginal social cost) production curve experienced by A1. And the new price point now shifts to P2 at which price A2 is willing to buy only quantity Q2. (See my modified figure below from Environmental Economics.)