EC211 · LESSON 08 / 08

8. Externalities

A factory earns revenue while nearby residents bear smoke damage absent from its bill. The market may produce more than is socially efficient.

Understand

What is this lesson explaining?

An externality affects others without being fully reflected in transaction prices or compensation. A negative externality makes social cost exceed private cost; a positive one makes social benefit exceed private benefit.

Private markets compare private benefits and costs, while efficiency compares MSB and MSC. With no benefit externality, demand measures MSB. Adding MEC to private cost identifies efficient output.

KEY MODEL

MSC = MPC + MEC

efficient output:MSB = MSC

MPCMarginal private costMECMarginal external costMSC / MSBMarginal social cost / benefit

See it on a graph

The graph is right here

Read the axes and original point first. Then change one value at a time and watch the curve or point move.

KEY MODEL

MB = 100 − Q

MPC = 20 + Q

MEC = 20

P1 (E₀=Market): Q=40, P=60Social : Q=30, P=70

D₀D₁MPCMSC₀MSC₁

Change demand: 0 price units added to the D intercept Marginal external damage: 20 model units

External marginal cost 20 places MSC above MPC. Social output 30 is no greater than market output 40. Assumes constant marginal damage; a corrective tax equals marginal damage.

Blue dashed: original · Solid: new state · E₀/A: original point · E₁/B: new point. Coincident points share a label; use the explanation to read each result.

A curve shifts when one of its non-axis conditions changes. An adjusting point on a fixed curve is movement along that curve, not a shift of it.

Quick check

NO TYPING

If MEC falls to 10 with other curves unchanged, what is efficient output?

Takeaway

Remember these two ideas

✓

The private market sets 100 − Q = 20 + Q, giving Q = 40. But MSC = 40 + Q.

Common mix-upAn externality does not imply banning all output. The model seeks equality of marginal social benefit and cost.

Assumptions and sources

Example MSB = 100 − Q, MPC = 20 + Q, and constant MEC = 20. Only a negative production externality is present, with no policy administration cost.

Pindyck & Rubinfeld, Microeconomics, 9th Global Edition, ch. 16, 18, pp. 638, 676 (PDF 640, 678); original examples and questions.