IBonomicsNegative Externality of ProductionSL
MicroeconomicsA diagram illustrating a negative externality of production, where the marginal social cost (MSC) exceeds the marginal private cost (MPC), leading to overproduction and welfare loss.
Curves and elements
- demand
- Demand Curve (MPB = MSB): Represents both marginal private benefit and marginal social benefit under the assumption there are no externalities in consumption.
- mpc
- MPC (Supply): Marginal private cost — the cost borne by producers only.
- msc
- MSC: Marginal social cost — the true cost to society, including external costs.
- price effect
- Price Effect: The market price (Pm) is lower than the socially optimal price (Popt).
- quantity effect
- Quantity Effect: The market produces more (Qm) than the socially optimal quantity (Qopt).
- welfare loss
- Welfare Loss: The triangle representing the deadweight loss due to the misallocation of resources caused by the externality.
Key explanations
- 1
Negative externalities of production occur when a firm’s production imposes external costs on third parties, such as pollution, without being reflected in market prices.
- 2
In the free market equilibrium, the firm produces at Qm where marginal private cost (MPC) = marginal private benefit (MPB), resulting in price Pm.
- 3
However, the socially optimal level of output is Qopt, where marginal social cost (MSC) = marginal social benefit (MSB).
- 4
Because MSC > MPC, the market overproduces (Qm > Qopt), and too many resources are allocated to the good.
- 5
The shaded triangle represents the welfare loss — the cost to society of the externality that is not accounted for in the market outcome.
Example exam question
Using a diagram, explain how a negative externality of production leads to market failure. Suggest a policy the government could use to correct the market outcome.
Show example answer
In the diagram, the free market equilibrium is at Qm and Pm, where firms only consider their private costs (MPC). However, production imposes external costs (e.g. air or water pollution), which shift the true cost curve to MSC. The socially optimal level of output is Qopt, at a higher price Popt, where MSC = MSB. The overproduction causes welfare loss, shown by the shaded triangle. The government could correct this market failure by imposing a Pigouvian tax equal to the external cost, shifting MPC to MSC and reducing output to Qopt.
