External Effect


Health Economics

  • External effects relate to the consequences of an action by one individual or group as they have an impact on others. There may be external costs and external benefits. Some are pecuniary, affecting only the value of other resources (as when a new innovation makes a previously valuable resource obsolete); some are technological, physically affecting other people (communicable disease is a classic example of this type of - negative - externality; network externality is another kind, referring to any change in the physical benefit that an agent derives from a good when the number of other agents consuming the same kind of good changes; antimicrobial resistance is another; herd immunity from vaccination is a positive example); some are utility effects that impinge on the subjective values of others (as when, for example, one person feels sympathy and distress at the sickness of another, or relief at their recovery). This latter is sometimes known as a caring externality (Culyer, 1976). When there are beneficial externalities of this kind, the standard maximizing behaviour assumed for individuals may not result in a Pareto optimum, notably if the marginal benefit received by the caring person is larger than the net marginal cost of the good or service to the consumer (that is, the marginal cost less the marginal value to the consumer).

    In the diagram, a consumer has a demand curve (marginal valuation curve) shown by MV 1 and would, assuming that the price is equal to marginal social cost (here assumed constant for convenience) select output rate Q 9. However, at that rate of consumption, some other caring individual or individuals also derive utility from this individual's consumption, as shown by the height of the curve labelled EMV (external marginal valuation) at this point. The optimal output rate is Q, beyond which the marginal cost to society exceeds the marginal value to society as shown by the vertical sum of the two curves D 1 and EMV. This is a Pareto optimal equilibrium, which might be obtained through subsidizing Q consumption, regulating it, or through direct exchange (as in charitable giving) between individuals (note here that in the optimum the marginal value placed by carers (Qa) is just equal to the difference between the marginal cost and the consumer's valuation). If the EMV fell to zero at a rate of consumption lower than Q9 there is still an externality but it is not 'Pareto-relevant', being entirely inframarginal. The analysis of external costs proceeds in a similar fashion but summing internal and external costs vertically rather than the internal and external 'demands'.

  • synonymExternality
    (written as external effect)