In example, each unit of output results in some effluent being dumped. The competitive industry output, therefore, is at Q, the intersection of the demand curve and the supply curve, MC 1. Because the demand curve measures the marginal benefit to consumers, the efficient output is given at Q, at the intersection of the marginal social cost MSC and demand D curve. Now, question arises whether the industrial output is efficient when there are externalities? As Figure 6 (b) shows, the efficient industry output level is the one at which the marginal benefit of an additional unit of output level is the one at which the marginal benefit of an additional unit of output is equal to the marginal social cost. The MSC curve represents the sum of the marginal cost of production and the marginal external cost for all steel firms. The marginal external cost associated with the industry output MEC 1, is obtained by summing the marginal cost of every person harmed at each level of output. In Figure 6(b), the MC 1 curve is the industry supply curve. Now consider what happens when all steel plants dump their effluent into rivers. However, the firm is producing too much output (Q, instead to Q) and generating too much effluent. Because only one plant is dumping effluent into the river in this case, the market price of the product is unchanged. The marginal social cost curve MSC intersects the price line at the output. In Figure 6(α) the marginal social cost curve is obtained by adding marginal cost and marginal external cost for each level of output (i.e. This marginal social cost is the marginal cost of production plus the marginal external cost of dumping effluent. The efficient output is the level at which the price of the product is equal to the marginal social cost of production. The curve is upward sloping for most forms of pollution because as the firm produces additional output and dumps additional effluent in the river, the incremental harm to the fish industry increases.įrom a social point of view, the firm produces too much output. This external cost is given by the marginal external cost (MEC) curve in Figure (6α). The firm maximizes profit by producing output at which marginal cost is equal to price (which equals marginal revenue, because the firm takes price as given).Īs the firms output changes, the external cost imposed on fishermen downstream also changes. The MC curve in part (α) gives a typical steel firms marginal cost of production. The price of steel is P t, at the intersection of the demand and supply curves in Figure 6b. We will analyze the nature of the externality in two steps first when only one steel plant pollutes, and the other when all steel plants pollute in the same way. It cannot alter its input combinations effluent can be reduced only by lowering output. Let us assume that the firm has a fixed proportions production function. Figure 6(a) shows the production decision of the steel plant in a competitive market, and part 6(6) shows the market demand and supply curves, assuming that all steel plants generate similar externalities. Let us take a example of a steel plant dumping waste in a river. Negative Externalities and Inefficiency :Īs externalities are not reflected in market prices, they can be a source of economic inefficiency. Thus the benefits are a positive externality. All the neighbours benefit from this activity, yet the decision to repaint and landscape probably did not take these benefits for the neighbours into account. While positive externality would occur when a homeowner repaints his house and plants an attractive garden. On the other hand the negative Externality arises because the steel firm has no incentive to account for the external costs that it imposes on fishermen when making its production decision. The more waste the steel plant dumps in the river, the fewer fish it will support. A negative Externality occurs, for example, when a steel plant dumps its waste in a river that fishermen downstream depend on for their daily catch.
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