How do externalities affect consumer surplus?

Externalities can have both positive and negative effects on consumer surplus.

Positive externalities occur when the consumption or production of a good or service benefits third parties who are not directly involved in the transaction. For example, if a neighbor installs solar panels on their house, it can reduce the overall pollution in the neighborhood and improve air quality for everyone. In this case, the positive externality increases the overall benefits derived from the consumption of the good, leading to an increase in consumer surplus.

On the other hand, negative externalities arise when the consumption or production of a good or service imposes costs on third parties. For instance, if a factory emits pollutants into the air, it can harm the health of nearby residents. In this case, the negative externality reduces the overall benefits derived from the consumption of the good, leading to a decrease in consumer surplus.

In summary, positive externalities increase consumer surplus by providing additional benefits beyond what consumers pay for, while negative externalities decrease consumer surplus by imposing costs that are not accounted for in the price of the good or service.