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Chapter 18.a. Externalities and Efficiency
Sometimes when producing or consuming a good, harmful or beneficial side effects occur that can affect
people beyond those directly involved in the market exchanges. If the side effects are positive they are
called external benefits and if they are negative they are called external costs. Immunizations create
external benefits, while pollution, congestion, noise, and theft create external costs. Externalities tend to
cause an inefficient allocation of resources because market prices do not take external costs and benefits
into account. In general, an externality exists when one person’s actions affect another’s well-being and no
payment is made.
External Costs
Suppose a steel mill is polluting the surrounding environment as a byproduct of producing steel. The
smoke produces $5 in damages for every ton of steel produced.
P
social
DWL
MCsocial
$5
MCprivate
Ps
B
Pp
private
A
D
Qs
Qp
steel
The MCprivate curve represents the marginal costs for the steel mill, but the damage from pollution must also
be considered because it is an extra cost to society. Therefore, the MCsocial curve represents the real costs
since it considers all the costs. Moving from the social optimum to the private optimum creates an increase
in total benefit (TB) of the area A and an increase in total cost (TC) of A+B. Therefore there is a
deadweight loss (DWL) of size B. The cost of moving from the social optimum to the private optimum is
greater than the benefit. This means that even though the quantity of steel produced is lower and the price
is higher at the point of social equilibrium, it is the preferred economic place to be because no DWL is
produced. If no steel were produced and therefore no pollution, society would be poorer by the area under
and to the left of the demand curve and above the MCsocial curve.
External Benefits
In contrast to a steel mill, which produces the external cost of pollution, a flower shop can produce external
benefits because people enjoy flowers. Suppose a flower shop produces $5 in benefits from the sale of its
flowers.
P
private
DWL
(under production)
MCprivate
$5 external benefit
MCsocial
Pp
BB
Ps
social
A
D
Qp
Qs
flowers
The MCprivate curve represents the marginal costs for the flower shop only, but the benefit from the flowers
must also be considered because flowers are considered beneficial to society. Therefore, the MCsocial curve
is lower than the MCprivate curve because the benefits offset some of the costs. Moving from the social
optimum to the private optimum creates a decrease in total benefit (TB) of the area A+B and a decrease in
total cost (TC) of A. A deadweight loss (DWL) of size B is created because flowers are under-produced at
the private optimum. The benefit of moving from the private optimum to the social optimum outweighs the
cost. At the social optimum, the quantity of flowers produced is greater and the price is lower, which is
good for consumers. Note that total cost should always be evaluated under the MCsocial curve.