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Market Failure Due to Externalities 457

form the new curve, MTC (marginal total cost). The original supply curve

embodies the internalcost of producing the chemical, that is, those borne by

producers. This marginal cost is simply $4 per liter. However, the true, full cost

of producing the chemical is the sum of all costs per unit, internal and external.

Thus, the full cost of expanding output comes to MIC MEC $4 $1 $5.

In the figure, this is shown by the curve MTC.

Once the externality is recognized, we can pinpoint the industry’s effi-

cient level of output using the logic of marginal benefits and costs. Optimal

industry output occurs at the intersection of the demand curve and the “full’’

supply curve, at output level Q* 8 million liters. Here, the marginal bene-

fit from the last unit consumed exactly matches the full (internal plus exter-

nal) marginal cost of producing this unit.^6 The efficient level of output is

lower than the competitive outcome, Qc10 million liters. By failing to rec-

ognize the externality, the competitive market produces too much output

and associated pollution, relative to the efficient outcome. Figure 11.1 also

shows the deadweight loss from the excess production, QcQ*—the trian-

gular shaded area where marginal benefits to consumers fall below the full

marginal costs of supply.

The inefficiency problems associated with externalities are caused by

incorrect pricing. The competitive price of $4 reflects only the marginal

internal costs of the chemical. But the full marginal cost is higher by the

amount of the marginal external cost (here, $1). In the figure, the efficient

price is actually $5, where P* MB MTC. This simple observation sug-

gests a direct way for a government regulator to implement the efficient

outcome:

An efficient means of regulation is to tax the producer of a negative externality an

amount exactly equal to the associated marginal external cost.

In the chemical example, the external cost of pollution is $1 (per extra

cubic foot of pollutant), so this is the appropriate tax. In other words, each

chemical firm pays a tax, T $1, for each cubic foot of pollution it dis-

charges. What is the effect of this tax on the typical chemical producer? By

continuing to produce the chemical with pollution as a by-product, the firm

incurs an out-of-pocket cost (per additional unit of output) equal to MIC 

T MIC MEC. Since the tax is set exactly equal to the marginal external

cost (MEC), the producer of the externality is made to pay its true social

cost. In this way, setting the right tax (T MEC) serves to “internalize the exter-

nality.” With the tax in place, the relevant industry supply curve is MTC (up

(^6) For the interested students, the figure’s demand curve is given by MB  9  .5Q. The competi-
tive equilibrium, Pc$4 and Qc10 million, is found by setting MB MIC. The efficient level
of output, P $5 and Q 8 million, satisfies MB MIC MEC.
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