Question

Using the supply and demand framework, demonstrate how a negative consumption externality leads to market inefficiency? How might the government help to eliminate this inefficiency?

Answer 1

When there is a negative externality the private cost to producers will be smaller than the social cost of their actions. In the enclosed graph the market equilibrium is the intersection of MPC and MSB i.e. at the quantity Q0. At Q0 the social surplus is equal to total social benefits minus total social costs i.e. a-d; and the market surplus will be total private benefits minus total private costs i.e. a+b+e. When there is a negative externality and optimal market equilibrium is Q1 (i.e. less than Q0) the social surplus will be area-a; and the market surplus will be area a + b. Compared to Q_O the social surplus increased by area d; thus in enclosed graph .area d was a deadweight loss at the optimal production level and was inefficient for society. Thus the intervention of government is required to make society better off. The government can impose taxation to eliminate this inefficiency and as size of the per-unit tax will equal P3 - P1 (or P2 - P0)