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I am trying to understand about externality in simple words, the book is quite confusing. So I wanted to know how externality makes the demand curve or supply curve shift attached the below diagram for reference

enter image description here

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  • $\begingroup$ If any of the answers helped you, please consider accepting it. Otherwise, you can ask for clarification. $\endgroup$
    – AKdemy
    Dec 12, 2022 at 1:28

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Each picture shows two different demands. One demand where people only consider private benefit and second counterfactual demand that takes into account also social benefits. This is not shift per se rather they are two counterfactual scenarios. Shift would occur if externality was not there before and then got introduced (let’s say because of technological change).

With positive externality demand based on private benefit only will be lower. The reason for that is that at every price people ignore the extra benefit to society so they consume less than they would if the externality would be internalized.

With negative externality exactly opposite happens. People do not take into account negative effect on society. Hence at any price people will demand more of the good than they would otherwise do.

The whole counterfactual demand is shifted because the societal benefit and societal costs are ignored at any price not just particular price.

For example, if a liter of gas costs $p$ and the societal damage from pollution is $x$ then the total social cost of liter of gas is $p+x$. In free market you only pay $p$, but in a counterfactual world where the externality is accounted for you would pay $p+x$. If original demand was for example $Q=100-2(p)$ and counterfactual demand is $Q=100-2(p+x)=100-2p-2x$. As you can see if you plot this, this extra $2x$ will make the counterfactual demand be shifted down.

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There are just demand shifts (changes in quantity demanded) in your picture.

For education:

The better education, the more educated the work force, the economy will have more professionals, and generally be better of. Since anyone deciding to get educated does not take this into account, education is under allocated and overall social demand, considering this external benefit, would be higher than the actual demand in the market. The free-market allocation is therefore resulting in a deadweight loss, represented by the triangle.

Smoking:

Cigarettes are harmful to people and smoking in public (next to other people) causes a negative externality. Also, someone needs to pay for the health bills of smoker who get sick over time. There is no compensation for this spill over effect on third parties and the marginal benefit for the consumer is greater than it is for the society.

Both explain the same logic, just in opposite directions - namely that marginal social benefits are different from marginal private benefits because the decision to consume will (indirectly) impact others.

Edit Social demand may not be used uniformly but there are sources that use the term social demand. After all, it is differences in quantities of demand that are the problem. A (normal market) demand curve represents the marginal benefit that accrues to consumers of the good - in other words, each point on the demand curve reflects the willingness to pay of the last consumer to purchase the good at the respective price. This does not incorporate the benefits to society though, which is why there is a social demand curve as well (which is the marginal social benefit curve).

For example Department of Economics University of California, Berkeley on P.4 where it is stated that

social demand = private demand + XB

where XB stands for eXternal Benefit.

Wikipedia

Similarly, there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demand in the market.

Also, K. Härnqvist, Social Demand Models

In a nutshell, externalities lead to individual decisions that are not optimal for society. The two examples above are affecting the demand side. On the supply side, you can have too much production with negative externalities (pollution for example) because firms do not consider the costs incurred to society.

In economics jargon, in perfect competition, the industry supply curve is the horizontal sum of all the individual supply curves of producers in a particular industry, which in in turn correspond to the producers marginal cost curves. However, this marginal cost does not include external costs / benefits that production imposes on others.

If there is a mechanism that considers the external costs, production (hence) supply will be lower.

Ironically, you asked for simply words and ended up with a lot of jargon. Entire books are filled with this topic and its either too simple, so that it is deemed incorrect, or too complex so that it cannot be understood. Either way, it will likely not help you much. Therefore, I recommend you to get a copy of Economics: European edition by Krugman et al. which provides the basic theory to understand why marginal cost / marginal benefit relates to supply / demand in chapter 9, and discusses externalities in chapter 19.

The book is far from being rigorous, but written by a a winner of the Nobel Memorial Prize in Economic Sciences, who wrote in his book The Return of Depression Economics and the Crisis of 2008 that

ideas must be presented in a way that is accessible to concerned people at large, not just those with economics Ph.D's. Anyway, the equations and diagrams of formal economics are, more often than not, no more than a scaffolding used to help construct an intellectual edifice. Once that edifice has been built to a certain point, the scaffolding can be stripped away, leaving only plain English behind.

I think he is very good at achieving this (especially in the book I recommended) and imho no one would be able to write a better answer here than the two chapters I referenced will give you.

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    $\begingroup$ I'm not sure that it is helpful in this context to use the term 'demand shift' or to describe social benefit as 'social demand'. Do you have a reputable source for these usages? Isn't the standard terminology here to equate private benefit with demand (ie market demand) and the second curve as just social benefit? $\endgroup$ Nov 11, 2022 at 14:53

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