AP_Krugman_Textbook

Private versus Social Costs

Now let’s turn briefly to consider a case in which production of a good
creates external costs—namely, the livestock industry. Whatever it is—
cows, pigs, chicken, sheep, or salmon—livestock farming produces prodi-
gious amounts of what is euphemistically known as “muck.” But that’s
not all: scientists estimate that the amount of methane gas produced by
livestock currently rivals the amount caused by the burning of fossil fuels
in the creation of greenhouse gases. From the point of view of society as a
whole, then, the cost of livestock farming includes both direct production
costs (payments for factors of production and inputs) and the external en-
vironmental costs imposed as a by-product of farming.
When a good like pork involves negative externalities, there is a difference between
the marginal cost to the firm,which we distinguish as the marginal private cost,and
the marginal cost to society,the marginal social cost of a good(or likewise of a service
or activity). The difference between the marginal private cost (MPC) and the marginal
social cost (MSC) is the marginal external cost(MEC)—the increase in external costs to
society from an additional unit of the good:

(75-2) MSC=MPC +MEC

Panel (a) in Figure 75.4 shows the marginal social cost curve, MSC,of livestock; it cor-
responds to the industry supply curve, S, shifted upwardby the amount of the marginal
external cost. (Recall that in a competitive industry, the industry supply curve is the
horizontal sum of the individual firms’ supply curves, which are the same as their

module 75 Externalities and Public Policy 739

Section 14 Market Failure and the Role of Government

The social cost of livestock produc-

tion is felt beyond the farm.

Photodisc

MSC of

livestock

S

D

(a) Negative Externality

Price,

marginal

social

cost of

livestock

Optimal

Pigouvian

tax

Quantity

of livestock

QOPT

POPT

PMSC

PMKT

QMKT

Marginal

external

cost

S

D

(b) Optimal Pigouvian Tax

Price

of

livestock

Quantity

of livestock

QOPT QMKT

Price to

consumers

after tax

Price to

producers

after tax

EMKT EMKT

OO

figure 75.4 Negative Externalities and Production

Livestock production generates external costs, so the marginal

social cost curve, MSC,of livestock, corresponds to the supply

curve, S,shifted upward by the marginal external cost. Panel (a)

shows that without government action, the market produces the

quantity QMKT. It is greater than the socially optimal quantity of

livestock production, QOPT,the quantity at which MSCcrosses

the demand curve, D.At QMKT,the market price, PMKT,is less

than PMSC,the true marginal cost to society of livestock produc-

tion. Panel (b) shows how an optimal Pigouvian tax on livestock

production, equal to its marginal external cost, moves the pro-

duction to QOPT,resulting in lower output and a higher price

to consumers.

The marginal private costof a good is

the marginal cost of producing that good,

not including any external costs.

The marginal social cost of a good is

equal to the marginal private cost of

production plus its marginal external cost.

The marginal external costof a good

is the increase in external costs created

by one more unit of the good.