Helpful Hint

Welfare Analysis of Externalities

By definition externalities have an impact on the welfare of people who are not taking
part in the market transaction. For example, pollution from a factory will have a
negative impact on people who live nearby while planting a beautiful garden in your
front yard will be beneficial to your neighbors. Naturally, then, economists want to
take into account externalities when thinking about welfare.

The main lesson is that markets with externalities are inefficient. The unregulated
market quantity will (almost) never be the quantity that maximizes social surplus.
Specifically, the market equilibrium quantity will either be greater than the efficient
quantity ("too much") or less than the efficient quantity (“too little”). This happens
because we are assuming market participants, consumers and producers, only
consider their own welfare and ignore the external effects on everyone else.

Before we analyze the welfare consequences of externalities we should review some

terminology:

Marginal private cost (MPC) is the cost to the producers. Earlier we called this
willingness-to-sell. The MPC is always represented by the supply curve.

The marginal social cost (MSC) of producing a good consists of the MPC plus the
marginal cost of any production externalities (MPE). In other words, MSC = MPC +
MPE.

Marginal private benefit (MPB) is the value of the marginal unit to consumers.
Earlier we called this willingness-to-pay. Analogous to the MPC, the MPB is always
represented by the demand curve.

The marginal social benefit (MSB) of consuming a good consists of the MPB plus the
benefit of any externality affecting consumption (MCE). In other words, MSB = MPB +
MCE.

Where there are no production externalities MSC = MPC + 0 = MPC, so the supply
curve will represent both the MPC and MSC. Similarly, when there are no
consumption externalities, the MSB = MPB + 0 = MPB, so the demand curve will
represent both the MPB and MSB.

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 P
S = MSC = MPC

D = MSB = MPB

Q MKT= Q EFF
Q

QMKT = QEFF when there are no externalities

Production Externalities

I. Negative Production Externalities

As an example, consider The Daily Catch restaurant, which can produce great
calamari, but only by causing the whole street to reek of fish and garlic. This foul
stench is (presumably) a negative production externality, so MPE > 0 and MSC > MPC.
This means that the MSC curve for calamari will be higher than the supply curve at all
points, since the cost to the restaurant of producing calamari does not take into
account the effect of the bad smell on other people—the externality. The difference
may be greater for small amounts of calamari, since once the street reeks adding a
little more smell doesn't make things much worse at the margin. The situation is
diagrammed below.

P MSC

S = MPC

Q
Generic Negative Production Externality

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Social surplus is maximized at the quantity for which the marginal social benefit
(MSB) from consuming the marginal unit equals the marginal social cost (MSC) of
producing it. If there are no externalities, marginal social benefit equals the marginal
private benefit, which is represented by the demand curve. Further, marginal social
cost equals the marginal private cost, which is represented by the supply curve. Thus,
the social surplus maximizing condition MSB = MSC is just the condition that supply
matches demand.

If there are externalities, however, the competitive market equilibrium level of output
is not the social surplus maximizing level of output, therefore the competitive market
equilibrium involves a deadweight loss.

Welfare for Negative Production Externality

With a negative externality the market produces "too much" calamari. Why?

If we can anthropomorphize the market, then the story goes like this: W hen the last
units of calamari were produced, the market thought that the benefits (what people
were willing to pay, the demand curve) slightly outweighed the costs of production
(the supply curve), so the market said "go ahead and trade." In fact, the costs to
society (the cost of production plus the marginal externality) were greater than the
benefits, so we want the market to say "don't produce anymore."

We can use the above diagram to find the total additional cost associated with the
negative externality. The additional cost is the difference between the MSC curve and
the MPC curve for all units produced. Thus, at QMKT the cost of the externality is B + C
+ D; at QEFF the cost of the externality is just B. Naturally the total cost is smaller when
the number of units produced is smaller. Also, notice that the cost of the externality
does not go away at the efficient quantity, but it is lessened.

What about overall social surplus? Is there a deadweight loss at Q MKT ? Yes! In fact,
that was implied when we said that the market produced "too much" of the good.
Since social surplus is maximized at QEFF, and QMKT is not equal to QEFF, there must be
deadweight loss associated with QMKT .

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There is a simple rule that can help us find the deadweight loss when dealing with
externalities: the deadweight loss is always the area between the MSB and MSC
curves in the region from QMKT to QEFF. Thus the area D represents the DWL in this
example because it is the area between the MSB and MSC curves that is located
between the dotted vertical lines at QMKT and QEFF. Why is this the DWL? QMKT - QEFF
represents units that should not have been produced but were. For each unit, MSC -
MSB is the total net cost to society from producing that unit. So, if we add up all these
net costs (the area in triangle D), we get the total social surplus lost because of the
overproduction, i.e. the DWL.

II. Positive Production Externalities

Suppose that in our calamari example people liked the smell of garlic and fish. Then
the Daily Catch would be generating a positive externality and the marginal social cost
of producing calamari would be less than the marginal private cost. In other words,
the social cost equals the private cost of production minus the benefits to people
walking down the street. In this case the market will produce less calamari than the
amount that would maximize social surplus.

P S = MPC

MSC

A D
Marginal Benefit of Externality

D = MSB = MPB

Q MKT Q EFF
Q
Generic Positive Production Externality

Once again we can look at the area between the MSB and MSC curves to find the
deadweight loss that occurs when QMKT is produced rather than QEFF. This area is now
C. In this case, the MSB > MSC so this area represents net benefit from production that
never happened. The DWL represents what could have been but never was because
“too little” was produced.

In sum, externalities can cause DWL in two ways:

1) DWL is created if "too much" is produced, namely units where MSC > MSB. This
will be true when there are only negative externalities.

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 2) DWL is created if "too little” is produced. Specifically, some units where MSB
> MSC were not produced. This will be true when there are only positive
externalities.

Consumption Externalities

So far we have discussed positive and negative externalities generated by the

production of goods. This was shown graphically as a divergence between the supply
curve and the MSC curve. There are also externalities generated by the consumption
of goods. For example, alcohol and garlic bread may have negative externalities
associated with their consumption (why?), while education and soap may have
positive externalities associated with their consumption (why?). As you might expect,
this is represented graphically as a divergence between the demand curve and the MSB
curve.

III. Negative Consumption Externalities

A graphical illustration of the case of a negative consumption externality is shown

below.

Generic Negative Consumption Externality

For negative consumption externalities, the additional cost associated with the
externality is the area between the demand curve and the MSB curve for all units
produced. Because this is a negative externality, the MSB curve lies below the
demand curve—the marginal benefit to society is less than the marginal benefit to
the consumer. The deadweight loss that occurs when QMKT is produced rather then
QEFF is area D, the area between the MSB and the MSC curves that is located between
QMKT and QEFF. Naturally, since this is a negative externality, the market is
consuming “too much” (QMKT > QEFF).

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IV. Positive Consumption Externalities

For positive consumption externalities, we have:

Generic Positive Consumption Externality

If this graph looks eerily familiar then you should look back at the previous page.
What are the main differences between the two graphs?

For positive consumption externalities, the additional benefit associated with the
externality is the area between the MSB curve and the MPB curve (demand) for all
units produced. In this case of a positive consumption externality, the deadweight
loss associated with producing QMKT is equal to C. This triangle shows the social
surplus that we forego by producing "too little" of the good (e.g. QMKT < QEFF).

One last note: it is possible to do find the deadweight loss by creating a welfare table
which would include consumer and producer surplus and the costs and benefits of
any externalities. But that is the hard way to do things. If you want to hone your
economic intuition you must learn to analyze welfare by thinking at the margin,
comparing MSB with MSC to determine QEFF and then comparing that outcome to
QMKT .