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Externalities are a loss or gain in the welfare of one party resulting from an activity of another party, without there being any compensation for the losing party.

This activity can be due to consumption or production of a good or service.
If the third party suffers due to this activity then it is known as negative externality.
When the third party gains from this activity is it known as positive externality.

Marginal Private Benefit is the benefit which is derived by private individuals in the consumption of a good or service.
Marginal Private Cost is the cost of producing, specifically marginal costs, which are incurred by private individual while producing a good or service.
Marginal Social Cost is the total cost to society as a whole for producing one further unit, or taking one further action, in an economy. This total cost of producing one extra unit of something is not simply the direct cost borne by the producer, but also must include the costs to the external environment and other stakeholders.
The market demand and supply curves therefore reflect the MPB and MPC accruing to buyers and sellers.
When there is no externality then the intersection MPB (demand) curve and MPC (supply) curve determine the equilibrium price. The price and quantity reflected at this point are ‘socially optimum’ level of production or consumption and the market is said to have allocative efficiency.
i.e. MPC=MPB.
At this point the consumer surplus is equal to the producer surplus.

However, this is usually not the case in real world. The production or consumption of goods and services do produce externalities and thus the concept of Marginal social benefits and Marginal social costs comes into being.


Types of Externalities

Externalities can result either from consumption activities or from production activities

There are four types of Externalities
1. Negative externality of Production
2. Negative externality of Consumption
3. Positive externality of Production
4. Positive externality of Consumption

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