Externalities and Market Inefficiency

In this section, we use the tools to examine how externalities affect economic well-being. The analysis shows precisely why externalities cause markets to allocate resources inefficiently. We examine various ways in which private individuals and public policymakers may remedy this type of market failure.
Welfare economics: A Recap
We begin by recalling the key lessons of welfare economics, To make our analysis concrete we will consider a specific market – the market for aluminium. Let us plot a figure for supply and demand curves in the market for aluminium.
As you would recall the supply and demand curves contain important information about costs and benefits. The demand curve for aluminium reflects the value of aluminium to consumers as measured by the prices they are willing to pay. At any given quantity, the height of the demand curve shows that willingness to pay off the marginal buyer. In other words, it shows the value of the consumer of the last unit of aluminium bought. Similarly the supply curve reflects the cost of producing aluminium. At any given quantity the height of the supply curve shows the cost of the marginal seller. In other words it shows the cost to the producer of the last unit of aluminium sold.
In the absence of government intervention, the price adjusts to balance the supply and demand for aluminium. The quality produced and consumed in the market equilibrium is shown as QMARKET in figure and is efficient in the sense that it maximizes the sum of producer and consumer surplus. That is, the market allocates resources in a way that maximizes the total value to the consumers who buy and use aluminium minus the total costs to the producers who make and sell aluminium.

Negative externalities
Now let’s suppose that aluminium factories emit pollution. For each unit of aluminium produced, a certain amount of smoke enters the atmosphere because this smoke creates a health risk for those who breathe the air, it is negative externality. How does this externality affect the efficiency of the market outcome.
Because of the externality the cost of producing aluminium to the soceity is larger than the cost to the aluminium producers. For each unit of aluminium produced, the social costs include the private costs of the aluminium producers plus the cost to those bystanders affected adversely by the pollution. Figure shows the social cost of producing aluminium. The social cost curve is above the supply curve because it takes into account the external costs imposed on society by aluminium producers. The difference between these two curves reflects the cost of the pollution.

What quantity of aluminium should be produced? To answer this question we once again consider what a benevolent social planner would do. The planner wants to maximize the total surplus derived from the market – the value of consumers of aluminium minus the cost of producing aluminium. The planner understands however that the cost of producing aluminium includes the external costs of the pollution.
The planner would choose the level of aluminium production at which the demand curve crosses the social costs curve. This intersection determines the optimal amount of aluminum from the standpoint of society as a whole. Below this level of production, the value of the aluminium, to consumers (as measured by the height of the demand curve ) The planner does not produce more than this level because the social cost of producing additional aluminium exceeds the value to consumers.

Note that the equilibrium quantity of aluminium QMARKET is larger than the socially optimal quantity. The reason for this inefficiency is that the market equilibrium reflects only the private costs of production. In the market equilibrium the marginal consumer values aluminium at less than the social cost of producing it. That is, QMARKET the demand curve lies below the social cost curve. Thus, reducing aluminium production and consumption below the market equilibrium levels raises the total well-being.
Source: Principles of Economics

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