Figure 17-1 A Pollution Externality in a Competitive Market
suppliers, employees, and customers. Its water-discharged effluent
damages natural ecosystems and imposes costs on all those who use the
nearby water for drinking or swimming. The emissions from its
smokestacks affect the cleanliness of the air and impose costs on people
who rely on its purity. The profit-maximizing paper mill neglects these
external effects of its actions because its profits are not directly affected by
them.
As shown in Figure 17-1 , allocative efficiency requires that the price
(the value consumers place on the marginal unit of output) be just equal
to the marginal social cost (the value of resources society gives up to
produce the marginal unit of output). When there are negative
externalities, social marginal cost exceeds private marginal cost because
the act of production generates costs for society that are not faced by the
producer.
A negative externality implies that a competitive free market will
produce more output than the allocatively efficient level; if the
externality can be internalized, allocative efficiency can be achieved.