Question

Diagrammatically show how the privately efficient production differs from the socially optimal production due to the presence of a negative externality, such as a cement factory polluting the air of a nearby town. Also verbally explain the diagram.

Answer 1

A negative externality is a cost imposed on a third party from producing or consuming a good.

This is a diagram for negative production externality. This shows the divergence between the private marginal cost of production and the social marginal cost of production.

A negative externality leads to overconsumption and deadweight welfare loss.

Diagram for Negative Externality

• In a free market, the output is where S (PMC) = D (PMB) @Q1.
• In a free market, it is assumed that people ignore the external costs. (e.g. when driving you consider the cost of petrol, but, not the fact that congestion and pollution increases causing problems for others.)

Because of externalities such as pollution, the social cost of driving is higher than the private cost. Therefore, in a free market we get overconsumption. This makes common sense, just think of rush hour traffic – there tends to be overconsumption of driving because people ignore the costs to others.

Socially efficient level of output

The socially efficient level of output occurs where the Social marginal cost (SMC) = Social Marginal Benefit (SMB). This occurs at output Q2.

The easiest policy to achieve the socially efficient level of output Q2 is using tax. The tax equals the external cost of production.