competitive free market will produce where the demand and supply
curves intersect—that is, at and If each unit of output of this good
also generates an external cost of MEC, then social marginal cost is
greater than private marginal cost by this amount. The allocatively
efficient level of output is where social marginal benefit equals social
marginal cost—that is, at The competitive free market therefore
produces too much output.
If firms in this industry are now required to pay a tax of $MEC per unit of
output, the private marginal cost curve, , shifts up to. The
externality will be internalized because firms will be forced to pay the
social marginal cost of their production. The new competitive equilibrium
will be and allocative efficiency will be achieved.
By producing where price equals private marginal cost and thereby
ignoring the externality, the firms are maximizing profits but producing
too much output. The price that consumers pay just covers the private
marginal cost but does not pay for the external damage. The social benefit
of the last unit of output (the market price) is less than the social cost
(private marginal cost plus the extra cost to society from the externality).
Reducing output would increase allocative efficiency and make society as
a whole better off.
Making polluting firms bear the entire social cost of their production is
called internalizing the externality. This leads them to produce a lower
level of output, as shown in Figure 17-1. Indeed, at the optimal level of
output, where the externality is completely internalized, consumer prices
would just cover the social marginal cost of production ( in the figure).
We would have the familiar condition for allocative efficiency that social
Qc pc.Q∗.MCP MCSp∗, Q∗,
P∗