Externalities and Gross Domestic Product Fundamentals

Externalities and Market Efficiency

In general, an externality is the influence of a person's actions on the welfare of another without any compensation for this effect. In particular, when a transaction between a buyer and seller directly affects a third party, this effect is called an externality. Externalities can be positive or negative.

If buyers and sellers do not take into account the external effects of their actions when they decide how much to buy or sell, market equilibrium is not efficient; i.e., it does not maximize the overall benefit of society as a whole because it has not taken into account the welfare of others who are affected.

The demand curve indicates the value of a good for consumers, expressed through the prices they are willing to pay. It is identified with the willingness to pay, or the value to consumers of the last unit purchased (consumer surplus). The supply curve reflects the costs of producing a good. It amounts to a willingness to sell, or the cost to businesses of the last unit sold (producer surplus).

The equilibrium quantity, Q*, maximizes the total value to buyers minus the total cost to the sellers. It is identified with the total market surplus. In the absence of externalities, market equilibrium is efficient. When there is a negative externality of production (such as pollution), the social cost of production is greater than the mere consideration of the private cost.

Understanding Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country over a period of time.

Key Features of GDP

• 1) Market value: GDP sums many different types of assets to obtain an indicator of economic activity. To homogenize all these assets, it uses market prices.
• 2) Of all: It includes all goods produced and sold legally. Therefore, it does not include illegal weapons, drugs, or the underground economy. Nor does it include those activities that are not realized through the market.
• 3) Goods and services: It includes both tangible goods and intangible items, the latter called services.
• 4) Final: It includes only the value of final goods. This requires making the distinction between a final good or service and an intermediate good or service. Thus, we define a final good or service as that which is acquired by the final user for direct consumption and not used as an intermediate factor. An intermediate good or service is one that is produced for incorporation in the production process of a final product.
• 5) Produced: GDP includes only goods produced in the current period, not the past. Transactions of goods produced in previous periods are not part of the GDP of the study period, except for the added value they might increase.
• 6) In a country: (A distinction between Interior / National) GDP measures the value of output produced within the geographical borders of a country, irrespective of the nationality of the producer.
• 7) For a period of time: Usually, the interval is one year or a quarter. GDP measures the flow of income and expenditure of the economy during this period.