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CHAPTER 18 • Externalities and Public Goods 663 The price of steel is P1 at the intersection of the demand and supply curves in Figure 18.1 (b) The MC curve in (a) gives a typical steel firm’s marginal cost of production The firm maximizes profit by producing output q1, at which marginal cost is equal to price (which equals marginal revenue because the firm takes price as given) As the firm’s output changes, however, the external cost imposed on fishermen downstream also changes This external cost is given by the marginal external cost (MEC) curve in Figure 18.1 (a) It is intuitively clear why total external cost increases with output—there is more pollution However, our analysis focuses on the marginal external cost, which measures the added cost of the externality associated with each additional unit of output produced In practice, the MEC curve is upward sloping for most forms of pollution: As the firm produces additional output and dumps additional effluent, the incremental harm to the fishing industry increases From a social point of view, the firm produces too much output The efficient level of output is the level at which the price of the product is equal to the marginal social cost (MSC) of production: the marginal cost of production plus the marginal external cost of dumping effluent In Figure 18.1 (a), the marginal social cost curve is obtained by adding marginal cost and marginal external cost for each level of output (i.e., MSC = MC + MEC) The marginal social cost curve MSC intersects the price line at output q* Because only one plant is dumping effluent into the river, the market price of the product is unchanged However, the firm is producing too much output (q1 instead of q*) and generating too much effluent Now consider what happens when all steel plants dump their effluent into rivers In Figure 18.1 (b), the MCI curve is the industry supply curve The marginal external cost associated with the industry output, MEC I, is obtained by summing the marginal cost of every person harmed at each level of output The MSCI curve represents the sum of the marginal cost of production and the marginal external cost for all steel firms As a result, MSCI = MCI + MECI Is industry output efficient when there are externalities? As Figure 18.1 (b) shows, the efficient industry output level is the level at which the marginal benefit of an additional unit of output is equal to the marginal social cost Because the demand curve measures the marginal benefit to consumers, the efficient output is Q*, at the intersection of the marginal social cost MSCI and demand D curves The competitive industry output, however, is at Q1, the intersection of the demand curve and the supply curve, MCI Clearly, industry output is too high In our example, each unit of output results in some effluent being dumped Therefore, whether we are looking at one firm’s pollution or the entire industry’s, the economic inefficiency is the excess production that results in too much effluent being dumped in the river The source of the inefficiency is the incorrect pricing of the product The market price P1 in Figure 18.1 (b) is too low— it reflects the firms’ marginal private cost of production, but not the marginal social cost Only at the higher price P* will steel firms produce the efficient level of output What is the cost to society of this inefficiency? For each unit produced above Q*, the social cost is given by the difference between the marginal social cost and the marginal benefit (the demand curve) As a result, the aggregate social cost is shown in Figure 18.1 (b) as the shaded triangle between MSC I, D, and output Q1 When we move from the profit-maximizing to the socially efficient output, firms are worse off because their profits are reduced, and purchasers of steel are worse off because the price of steel has increased However, these losses are less than the gain to those who were harmed by the adverse effect of the dumping of effluent in the river In §8.3, we explain that because a competitive firm faces a horizontal demand curve, choosing its output so that marginal cost is equal to price is profit-maximizing • marginal external cost Increase in cost imposed externally as one or more firms increase output by one unit • marginal social cost Sum of the marginal cost of production and the marginal external cost In §9.2, we explain that, absent market failure, a competitive market leads to the economically efficient output level
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