NEGATIVE EXTERNALITIES IN PRODUCTION

At the market equilibrium involving private costs only (Q_M), not all information is known by the market. The market is overproducing, compared to what would exist if all costs (including external costs) were reflected in the supply curve.

For illustration look at Q_1. From a private cost perspective, it would appear that we are underproducing the good (the benefit to the buyer still appears to be greater than the cost to the producer). But by incorporating the external costs (of pollution or other "negative externalities") we can see that the market is in fact overproducing the good (the benefit to the buyer is less than cost to society at Q₁). The result is a negative effect on consumer and producer surplus. Society’s surplus thus can’t be at a maximum at any value (such as Q₁ or Q_M) greater than Q_OPT .

In order to reach the "best" (optimum) surplus for society, production should be cut back, so that the benefit to the buyer of a unit of the good will be no less than the cost to society, which occurs at Q_OPT. Government can encourage production to be cut back by means of a tax.

When one taxes the producer per unit produced, equal to the amount of the external cost incurred by society (similar to a sales tax), the effective price the producer must receive can be made greater than indicated by "private cost" supply curve. (Supply curve shifts up by the amount of the tax.) The producer must have the original price to cover the private costs of production–that is what the "private" supply curve tells us. With the tax, the price received needs to be higher, so the curve shifts up, and now coincides with the "social cost" curve. This will bring equilibrium to the "optimum" (correct) amount Q_OPT.

POSITIVE EXTERNALITIES IN PRODUCTION

At the market equilibrium (Q_M) which neglects "spillover benefits"-- also known as "positive externalities" -- not all information is known by the market. The market is underproducing, compared to what would exist if all benefits (including external benefits) were known to the market.

For illustration look at Q_1. From a private perspective (original supply curve), it would appear that we are overproducing the good (the benefit to the buyer appears to be less than the cost to the producer). But by incorporating the external benefits (of technology or other "positive externalities") we can see that the market is in fact underproducing the good (the benefit to the buyer is still greater than cost to society at Q₁). The result is a failure to gain all of consumer and producer surplus that is available to society, and production needs to be increased in order to do so. Society’s surplus can’t be at a maximum at any value (such as Q₁ or Q_M) less than Q_OPT .

In order to reach the "best" (optimum) surplus for society, production should be encouraged to increase to the level of Q_OPT, so that the benefit to the buyer of a unit of the good will be no greater than the cost to society. Government can do this by means of a subsidy.

When one subsidizes production per unit, the effective price the producer must receive is less than indicated by "private cost" supply curve. (Supply curve shifts down by the amount of the subsidy.) The producer must have a certain price to cover the private costs of production–that is what the "private" supply curve tells us. With the subsidy, the price received doesn’t need to be so high. So the curve shifts down, and now coincides with the true "social cost" curve. This will bring equilibrium to the "optimum" (correct) amount Q_OPT.

Class Notes | Clint Johnson |  Economics & Finance | Departments & Majors
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