Review the concept of externalities from Chapter 5, page 148. If a market is a monopoly, will a negative externality in production always lead to production beyond the level of economic efficiency? Use a graph to illustrate your answer.

Externalities and Economic Efficiency

When you consume a Big Mac, only you benefit, but when you consume a college education, other people also benefit. College-educated people are less likely to commit crimes, and by being better-informed voters, they are more likely to contribute to better government policies. So, although you capture most of the benefits of your college education, you do not capture all of them.

When you buy a Big Mac, the price you pay covers all of the cost McDonald's incurs in producing the Big Mac. When you buy electricity from a utility that burns coal and generates carbon dioxide, though, the price you pay covers some of the costs the utility incurs, but does not cover the cost of the damage carbon dioxide does to the environment.

So, there is a positive externality in the production of college educations because people who do not pay for them will nonetheless benefit from them. There is a negative externality in the generation of electricity. For example, if fish and wildlife have disappeared from a lake because of acid rain generated by a utility, people who live near the lake incur a cost-even though they may not purchase electricity from that utility.

The Effect of Externalities

Externalities interfere with the economic efficiency of a market equilibrium. A competitive market achieves economic efficiency by maximizing the sum of consumer surplus and producer surplus (see Chapter 4). But that result holds only if there are no externalities in production or consumption. An externality can cause a difference between the private cost of production and the social cost.

• The private cost is the cost borne by the producer of a good or service.

• The social cost is the total cost of producing a good or service, and it is equal to the private cost plus any external cost, such as the cost of pollution.

Unless there is an externality, the private cost and the social cost are equal.

An externality can also cause a difference between the private benefit from consumption and the social benefit.

• The private benefit is the benefit received by the consumer of a good or service.

• The social benefit is the total benefit from consuming a good or service, and it is equal to the private benefit plus any external benefit, such as the benefit to others resulting from your college education.

Unless there is an externality, the private benefit and the social benefit are equal.

How a Negative Externality in Production Reduces Economic Efficiency Typically, economists assume that the producer of a good or service must bear all the costs of production. But we now know that this assumption is not always true. In the production of electricity, private costs are borne by the utility, but some external costs of pollution are borne by people who are not customers of the utility. The social cost of producing electricity is the sum of the private cost plus the external cost. Figure 5.1 shows the effect on the market for electricity of a negative externality in production.

S1 is the market supply curve and represents only the private costs that utilities have to bear in generating electricity. Firms will supply an additional unit of a good or service only if they receive a price equal to the additional cost of producing that unit, so a supply curve represents the marginal cost of producing a good or service (see Chapter 4). If utilities also had to bear the cost of pollution, the supply curve would be S2, which represents the true marginal social cost of generating electricity. The equilibrium with price PEfficient and quantity QEfficient is efficient. The equilibrium with price PMarket and quantity QMarket is not efficient.

To see why, remember that an equilibrium is economically efficient if economic surplus-which is the sum of consumer surplus plus producer surplus-is at a

maximum (see Chapter 4). When economic surplus is at a maximum, the net benefit to society from the production of the good or service is at a maximum. With an equilibrium quantity of QEfficient, economic surplus is at a maximum, and the equilibrium is efficient. But, with an equilibrium quantity of QMarket, economic surplus is reduced by the deadweight loss-equal to the yellow triangle in Figure 5.1-and the equilibrium is not efficient. The deadweight loss occurs because the supply curve is above the demand curve for the production of the units of electricity between QEfficient and QMarket. That is, the additional cost-including the external cost-of producing these units is greater than the marginal benefit to consumers, as represented by the demand curve. In other words, because of the cost of the pollution, economic efficiency would be improved if less electricity were produced.
We can conclude the following: When there is a negative externality in producing a good or service, too much of the good or service will be produced at market equilibrium.
How a Positive Externality in Consumption Reduces Economic Efficiency We have seen that a negative externality interferes with achieving economic efficiency. The same holds true for a positive externality. In earlier chapters, we assumed that the demand curve represents all the benefits that come from consuming a good. But a college education generates benefits that are not captured by the student receiving the education and so are not included in the market demand curve for college educations. Figure 5.2 shows the effect of a positive externality in consumption on the market for college educations.
If students receiving a college education could capture all its benefits, the demand curve would be D2, which represents the marginal social benefits. The actual demand curve is D1, however, which represents only the marginal private benefits received by students. The efficient equilibrium would occur at price PEfficient and quantity QEfficient. At this equilibrium, economic surplus is maximized. The market equilibrium, at price PMarket and quantity QMarket, will not be efficient because the demand curve is above the supply curve for production of the units between QMarket and QEfficient. That is, the marginal benefit-including the external benefit-of producing these units is greater than the marginal cost. As a result, there is a deadweight loss equal to the area of the yellow triangle. Because of the positive externality, economic efficiency would be improved if more college educations were produced.
We can conclude the following: When there is a positive externality in consuming a good or service, too little of the good or service will be produced at market equilibrium.
Externalities and Market Failure
We have seen that because of externalities, the efficient level of output may not occur in either the market for electricity or the market for college educations. These are examples

of market failure-situations in which the market fails to produce the efficient level of
output. In Section 5.3, we will discuss possible solutions to problems of externalities.
But, first, we need to consider why externalities occur.
What Causes Externalities?
Governments need to guarantee property rights in order for a market system to function well (see Chapter 2). Property rights refer to the rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. Property can be tangible or physical, such as a store or factory. Property can also be intangible, such as the right to an idea. Most of the time, the governments of the United States and other high-income countries do a good job of enforcing property rights, but in certain situations, property rights do not exist or cannot be legally enforced.
Consider the following situation: Lee owns land that includes a lake. A paper company wants to lease some of Lee's land to build a paper mill. The paper mill will discharge pollutants into Lee's lake. Because Lee owns the lake, he can charge the paper company the cost of cleaning up the pollutants. The result is that the cost of the pollution is a private cost to the paper company and is included in the price of the paper it sells. There is no externality, the efficient level of paper is produced, and there is no market failure.
Now suppose that the paper company again builds its paper mill on privately owned land but discharges its pollutants into a lake that is owned by the state government rather than by an individual. In the absence of any government regulations, the company can discharge pollutants into the lake without having to pay a fee. The cost of the pollution will be external to the company because it doesn't have to pay the cost of cleaning it up. The paper mill will produce a quantity of paper that is greater than the economically efficient level, and a market failure will occur. Or, suppose that Lee owns the lake, but the pollution is caused by acid rain generated by an electric utility hundreds of miles away. The law does not allow Lee to charge the electric utility for the damage caused by the acid rain. Even though someone is damaging Lee's property, he cannot enforce his property rights in this situation. Once again, there is an externality, and the market failure will result in too much electricity being produced.
If you buy a house, the government will protect your right to exclusive use of that house. No one else can use the house without your permission. Because of your property rights in the house, your private benefit from the house and the social benefit are the same. When you buy a college education, however, other people are able to benefit from it. You have no property right that will enable you to prevent them from benefiting or to charge them for the benefits they receive. As a result, there is a positive externality, and the market failure will result in too few college educations being supplied.
We can conclude the following: Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations.

Transcribed Image Text:

Price of Deadweight electricity S2 = marginal social cost loss S, = marginal private cost Efficient equilibrium Cost of PEficient acid rain PMarket Market equilibrium Demand Quantity of electricity QMarket QEfficient Price of Positive a college education externality Deadweight loss Supply PEtficient Efficient equilibrium PMarket Market" equilibrium D2 = marginal social benefit D,= marginal private benefit OMarket Quantity of college educations QEfficient