Third Party Costs and Benefits

Part I: Please read about Third Party Costs and Benefits.


Smoking creates external costs. The smoker is satisfied and the tobacco company gains, but third parties often have to put up with the resulting smell and litter as well as the hazard to health from breathing air containing cigarette smoke.
People who drive under the influence of alcohol are much more likely to cause accidents than do other drivers. These accidents cause third parties to suffer personal injury and/or property damage.
The productive work of maintaining one's house is an example of an external benefit provided by a consumer who also acts as a producer. Third party benefits are also called spillover benefits.  If people landscape their yards, paint and otherwise maintain their houses, the whole neighborhood looks better. The houses are then usually worth more than houses in comparable neighborhoods in which the owners do not maintain their houses to an equal extent.

Education also creates a spillover benefit or positive externality. On the whole, people's productivity increases with their level of education. A higher level of education also tends to be correlated with better health and a lower crime rate. Third parties benefit from this greater productivity, the fewer calls on health care services, and the lower burden on the police and the judiciary.

Let's now analyze the economics of third party costs and benefits using supply and demand graphs:


Chart 1 No Third Party Effects

Chart 1 shows market equilibrium with no third-party effects. The equilibrium price and quantity result in an efficient allocation of resources (no shortages or surpluses).


Chart 2: How do we reduce the number of disposable diapers going into the landfills?

In Chart 2, there are third-party costs

S is the supply curve when these costs are paid by the community. It is the same as S above. 

S1 shows the supply curve if producers are forced to pay the third-party costs. That is, supply decreases. Notice that when the community pays the third-party costs, the producer's price is lower and production is higher than when the producer pays all the costs. This situation highlights a tendency for an external cost to result in over-production if the costs are not paid  by the producer. 

When producers are forced to pay the cost which would otherwise be borne by the community, we call this "internalizing the externality." An example of this might be if manufacturers of disposable diapers were forced to pay for the garbage/dump/landfill costs which are a huge problem because disposable diapers do not bio-degrade very quickly and are filling up the landfills around the country.


Chart 3 How do we immunize as many people as possible against a highly contagious disease?

In Chart 3, D represents market demand for a product. D1 represents demand for the product if all positive externalities (spillover benefits) are included in the transaction, i.e., if the buyers received all of the benefits. The market equilibrium amount, Q, is less than the optimal amount. 

Suppose that D represents private demand for immunization shots against a highly contagious disease. The social benefits of containing the disease or eradicating it are not included in the market decision. If they were, the demand curve would be at D1. Notice that fewer shots are given with demand at D than at D1. The optimal number of shots is at Q1, where all the benefits are included as a part of demand. 

One manner of reaching Q1 is to reduce the cost of the shots (e.g., by a government subsidy to those who administer the shots). Then supply rises to S1, and society will receive the optimal amount of the product.

Third-party cost and benefits-or externalities- are the effects of production or consumption of a good or service on people (the third parties) who are not involved in the transaction.

To understand externalities, let's first look at a transaction that has none. Figure 1 shows the market interaction between a supplier and a consumer of a good. Let's say they are producing and  consuming organically grown apples. The supplier is one of the several producers of apples, and the consumer is one of the many consumers of apples. In the transaction, our apple eater receives the apples and in turn pays the farmer, as indicated by the lines. The supplier has absorbed many costs of production but is satisfied with the transaction because of the payment received from the consumer The consumer is happy with the transaction because of the benefit derived from eating the apples. in such transactions, the producers and consumers bear all the costs and benefits. Suppliers pay all costs of production; no one else bears any costs or receives any benefits from engaging in production. Consumers receive the benefit of consumption; their consumption brings no costs or benefits to others.

Organically grown apples are used in the transaction described above because real-world examples of products free from external benefits and costs are hard to find. If the apple farmer had used fertilizer and pesticide, many other people might have been affected. What might some of these effects have been?

External costs and external benefits are directly opposite to each other. If the external effect is negative, it is called a negative externality or an external cost. If the external effect is beneficial, it is called a positive externality or an external benefit.


Next, let's use Happy Faces, again, and Sad Faces to illustrate third-party costs and benefits. I know this is a bit simplistic but I believe it best illustrates my point. Each illustration in Figure 2 shows a supplier, a consumer, and a third party. The suppliers have S's for hair, the consumers, C's, and the third parties T's.


Part A in Figure 2 depicts an external cost of production. The seller and consumer have happy faces. The consumer receives the product and pays the seller. Because this is a voluntary transaction, the consumer thinks the payment for the produce is worthwhile. The seller also has a happy face since the payment provides an acceptable price for the product. However, Part A shows a third party who is sad because of a negative effect from production. An example of an external cost of production is pollution resulting from a manufacturing process. Let us suppose that in Part A the producer's operations pollute air or water and the producer does not prevent the pollution or clean it up afterward. Hence, the producer's price does not include the cost of dealing with the pollution. The consumer also benefits because if the producer's cost does not cover the cost of dealing with the pollution, the price to the consumer is lower that it otherwise would be. However, third parties who must now contend wit dirtier air or more polluted water suffer increased costs such as health problems, reduced recreational opportunities, and higher taxes for water purification. Because the price of the product is lower than it would be if the producer paid all the costs of dealing with the pollution, the unregulated market economy will produce too much of the product. In general, because third-party costs are not reflected in the market prices paid by buyers, goods or services that result in external cost will be overproduced  in an unregulated market.

Part B in Figure 2 depicts an external benefit of production or spillover benefit. The external benefit again comes from a market transaction, but this time it brings a happy face to the third party, for in this instance, third parties benefit, even thought they pay none of the costs of producing the product. An example is a dam built to generate electric power. Among the third-party or spillover benefits might be flood control for downstream residents and a lake for recreation.  People whose homes are no longer subject to floods or who fish, swim, and go boating in the lake would also benefit from the dam. However, in the absence of a subsidy or other non-market  means of reducing producer costs, goods with external benefits tend to be under-produced in an unregulated market. Thus, if the dam must be paid for from electricity charges only, it might not be built, because the electricity charges alone may not be sufficient to permit the dam to operate at a profit. (There are some third party costs, as well, that result from the building of a dam (especially very big dams), namely the destruction of habitat and white water rafting, and perhaps even the destruction of nearby communities). Thinking at the margin, the community should weigh all the costs and benefits before going ahead with the building of the dam.

Because an unregulated market under produces products with external benefits and over-produces products with external costs, government may intervene to correct these situations. 

For instance, the government sometimes takes action designed to raise the price of products that impose external costs. It can require firms to meet certain pollution standards. This increases costs of production, decreases supply, and raises the equilibrium price. Less of the product will be produced than in an unregulated market. There also will be less pollution.

The government sometimes subsidizes the production of products with external benefits. If the government finances part of the cost of a hydroelectric dam, the dam may become practical to build. If the power company had to pay all the costs, it might not build the dam; consumer demand for a recreational lake is not reflected in the demand for electricity.

Private market decisions that are motivated by self-interest tend to ignore external costs and benefits. In those situations, a case may be made for government intervention.


Part II: Now....please complete the following handout. I have a copy of this for you to do. Feel free to work together with people at your table.