Micro CHAPTER 6.2:

CHAPTER SUMMARY

Because so much production and consumption has externalities (positive or negative effects on people not directly involved in production & consumption), free markets often do not actually result in production of the socially optimal quantity of most products.

In the case of production, the marginal private cost (MPC) can be different from the marginal social cost (MSC), because the firm does not have to pay for externalities of production. The MPC curve is the same as the supply curve, because it only captures the private costs of production. However, the MSC curve is to the left of the MPC curve because it also includes the additional "production costs" that society experiences as negative externalities (like pollution). As you can see in the first chart, the different between the MSC and MPC curve results in the free market that produces a higher quantity and lower price than would be socially optimal. This shows how free markets fail to address externalities of production and consumption.

Similarly, if my consumption of something has positive externalities on other people, the marginal social benefit (MSB) curve is going to be higher than the marginal private benefit (MPB) curve, since when I am making a purchasing decision about whether to buy a shovel, I only think about my personal benefit, not the benefits of my neighbors. This is why the MPB curve is equal to the demand curve. Just like in our previous example, this results in a deadweight loss, because the socially optimal outcome is actually where the MSB curve meets the MSC curve.

It is important to note that this idea is based on homo economicus, the "rational" person who only ever thinks of their own personal benefit. In practice, many people consider the effects of their decisions on others, which means the demand curve may be somewhere in between the theoretical MPB and MSB curve. Similarly, many companies do consider the negative externalities associated with production.

So what is the role of government in markets that have externalities? When MSC > MPC, they can put a per-unit tax on the production of a good, equal to the difference between the two curves. Adding this tax to the cost of production should shift the supply/MPC curve back to the MSC curve. Similarly, if the consumption of a production has positive externalities, they can offer a per-unit subsidy (payment for making or purchasing something) to people who buy the product, which should shift the demand/MPB curve to match the MSB curve. We can also give subsidies for production or tax consumption as needed. Doing this can eliminate the deadweight loss and help the market return to the socially optimal quantity and price.

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