Externalities
- Distinguish negative from positive externalities and their efficiency effects
- Compare the market outcome with the socially optimal outcome
- Explain how taxes and subsidies correct externalities
When costs or benefits spill over
An externality is a cost or benefit imposed on a third party not involved in a transaction — a spillover the market price ignores. With a negative externality (pollution), production imposes costs on others, so the marginal social cost (MSC) exceeds the marginal private cost (MPC). With a positive externality (vaccination, education), the activity confers benefits on others, so the marginal social benefit (MSB) exceeds the marginal private benefit (MPB). Because private decision-makers weigh only their private costs and benefits, the market outcome is inefficient whenever externalities are present.
Overproduction and underproduction
The market equilibrium sets marginal private cost equal to marginal private benefit, but the social optimum occurs where marginal social cost equals marginal social benefit. A negative externality leads to overproduction: the market quantity exceeds the socially optimal quantity, and the gap creates deadweight loss (units produced whose social cost exceeds social benefit). A positive externality leads to underproduction: the market makes less than the optimal amount, again with deadweight loss (valuable units society wants but the market does not provide).
Correcting externalities
Government can nudge the market to the social optimum by internalizing the externality. For a negative externality, a per-unit (Pigouvian) tax equal to the external cost raises private cost up to social cost, reducing output to the optimal quantity. For a positive externality, a per-unit subsidy equal to the external benefit raises private benefit up to social benefit, increasing output to the optimum. Other tools include regulation, tradable pollution permits, and — for small-scale problems with clear property rights — private bargaining (the Coase theorem).
A factory produces steel and emits pollution. The marginal private cost of the last unit is $40, but it also imposes $15 of pollution cost on nearby residents. The marginal social benefit of that unit is $45. Is the market overproducing, and what corrective policy restores efficiency?
- 1.Marginal social cost = marginal private cost + external cost = $40 + $15 = $55.
- 2.Compare MSC to MSB for this unit: MSC ($55) > MSB ($45), so this unit’s social cost exceeds its social benefit.
- 3.Since the market (guided by MPC = $40 < MSB = $45) would produce this unit, the market overproduces relative to the social optimum.
- 4.A corrective (Pigouvian) tax of $15 per unit — equal to the external cost — raises private cost to social cost, cutting output to where MSB = MSC.
A good generates a positive externality in consumption (for example, vaccinations). Left to the free market, this good will be:
Match the correction to the externality: a negative externality (overproduction) calls for a tax; a positive externality (underproduction) calls for a subsidy. Prescribing a tax for a positive externality (or vice versa) pushes the market further from the optimum.
In a market with a negative production externality, which policy most directly moves the market to the socially optimal quantity?
On externality graphs, draw both the private and social curves (MPC vs. MSC, or MPB vs. MSB), mark the market quantity and the optimal quantity where MSB = MSC, and shade the deadweight-loss triangle between them. State the corrective tax or subsidy as the vertical distance equal to the external cost or benefit.
Answer the 2 checkpoints as you read.
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