Question

why integrating different types of businesses may reduce the problem of externality?

Answer 1

Externalities are effects of production/consumption that affect people not involved in the original transaction. In other words it just means that a good has effects other than the effect on the buyer and the effect on the seller.

A positive externality benefits people not involved in the original transaction. If a volunteer group comes out and cleans the beaches, nearby residents (who did not participate) get nice clean beaches to look at and play on at no cost to them.

A negative externality harms people not involved in the transaction. If someone is selling sporting equipment to another person and dumps the waste into the water near your lakefront home, that is a negative externality because you were harmed by the lake being contaminated even though you didn’t buy or sell the sporting equipment.
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Positive externalities can't be said to be a problem (in fact the problem is that they're undersupplied so we wan't more of them!), so I'll continue assuming the question is asking about negative externalities e.g. the smoke emissions example.

The gist of it is at follows: a representative firm decides quantity (and then price, if the firm has monopolistic price-setting influence) by equating MR = MC. In other words the profit maximizing quantity is such that the increment in revenue from sale of one more unit (aka Marginal Revenue or MR) is equal to the increment in cost from producing that last unit (aka Marginal Cost or MC). In a competitive market, the MR is the same as the market price which is determined by the intersection of industry demand and industry supply curves but which each individual firm takes as exogeneous.

When doing this cost-benefit analysis, firms neglect the negative social cost from each unit of output. They only look at their own cost aka Private Marginal Cost or PMC. There's also a Marginal External cost or MEC, which is the external (e.g. environmental) cost of producing an additional unit. The sum (PMC + MEC) gives SMC, which is the true marginal cost to society of another unit of production.


^ the figure shows the SMC is above the MC. Thus for a given market price P private firms overproduce by choosing output level Qp, which is greater than the socially optimal output level Q-star.
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