662 PART • Information, Market Failure, and the Role of Government • externality Action by either a producer or a consumer which affects other producers or consumers, but is not accounted for in the market price daily catch The more waste the steel plant dumps in the river, the fewer fish will be supported The firm, however, has no incentive to account for the external costs that it imposes on fishermen when making its production decision Furthermore, there is no market in which these external costs can be reflected in the price of steel A positive externality occurs when a home owner repaints her house and plants an attractive garden All the neighbors benefit from this activity, even though the home owner’s decision to repaint and landscape probably did not take these benefits into account Negative Externalities and Inefficiency In §6.3, we explain that with a fixed-proportions production function, it is impossible to substitute among inputs because each level of output requires a specific combination of labor and capital Because externalities are not reflected in market prices, they can be a source of economic inefficiency When firms not take into account the harms associated with negative externalities, the result is excess production and unnecessary social costs To see why, let’s take our example of a steel plant dumping waste in a river Figure 18.1 (a) shows the production decision of a steel plant in a competitive market Figure 18.1 (b) shows the market demand and supply curves, assuming that all steel plants generate similar externalities We assume that because the firm has a fixed-proportions production function, it cannot alter its input combinations; waste and other effluent can be reduced only by lowering output (Without this assumption, firms would be jointly choosing among a variety of combinations of output and pollution abatement.) We will analyze the nature of the externality under two circumstances: first when only one steel plant pollutes and, second, when all steel plants pollute in the same way Price MSC Price MC MSC I S ϭ MC I P* P1 P1 MEC I MEC D Firm output q* q (a) Q* Q1 Industry output (b) F IGURE 18.1 EXTERNAL COST When there are negative externalities, the marginal social cost MSC is higher than the marginal cost MC The difference is the marginal external cost MEC In (a), a profit-maximizing firm produces at q1, where price is equal to MC The efficient output is q*, at which price equals MSC In (b), the industry’s competitive output is Q1, at the intersection of industry supply MCI and demand D However, the efficient output Q* is lower, at the intersection of demand and marginal social cost MSCI