When there is an externality, either too much or too little of the good is
produced. If the market for this good is perfectly competitive and there is
no government intervention, the equilibrium is shown by and
both parts of the figure.
Part (i) shows a situation where the production or the consumption of the
good imposes costs on third parties. This is a negative externality—social
marginal costs are above The vertical distance between
and reflects the per-unit external cost. The allocatively
efficient quantity is where equals But the free market will
produce too much of the good.
Part (ii) shows a situation where the production or consumption of the
good confers benefits on third parties. This is a positive externality—social
marginal benefits are , above. The vertical distance between
and reflects the per-unit external benefit. The allocatively
efficient quantity is , where equals But the free market will
produce too little of the good.
Consider the case of a firm whose production process for steel generates
harmful smoke as a by-product. Individuals who live and work near the
firm bear real costs as they cope with breathing (or trying to avoid
breathing) the harmful smoke. When the profit-maximizing firm makes
its decision concerning how much steel to produce, it ignores the costs
that it imposes on other people. This is a negative externality; social
marginal costs are greater than private marginal costs. In this case,
because the firm ignores those parts of social cost that are not its own
private cost, the firm will produce too much steel relative to what is
allocatively efficient.
A second example involves an individual who renovates her home and
thus improves its external appearance. Such improvements enhance the
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