9781118041581

The difficulty posed by externalities is that the party producing the exter-

nality has no incentive to consider the external effects on the other, affected

parties. The general rule is this:

Left to its own devices, the party in question will act so as to produce too much of

a negative externality and too little of a positive externality.

In short, externalities—either positive or negative—are a potential source of

economic inefficiency.

To illustrate the externality problem, consider production of a chemical

that generates air pollution as a by-product. Figure 11.1 shows the competitive

market supply and demand for the chemical. The market equilibrium occurs

at the intersection of demand and supply, here at price Pc$4 per liter and

industry output Qc10 million liters. In the absence of any externality, this

competitive outcome would be efficient.

Suppose, however, that an externality, pollution, is present. To keep things

simple, we assume that a known, fixed amount of pollution—say 1 cubic foot

of noxious gas—is generated per liter of chemical produced and that each

cubic foot causes $1 in harm.

In Figure 11.1, the $1 external cost associated with pollution is added on

top of the chemical industry supply curve, MIC (marginal internal cost), to

456 Chapter 11 Regulation, Public Goods, and Benefit-Cost Analysis

Q

Chemical Output (Millions of Liters)

Price

Efficient

outcome:

P* = $5,

Q* = 8

(^3)
Industry
demand
$9
8
7
6
5
4
(^1)
2
0 246810
MTC
MIC
12
External cost
of pollution: $1
Internal cost
of production Unregulated
competitive
outcome:
Pc = $4,
Qc = 10
Total
marginal
cost
135791113
FIGURE 11.1
Production
Accompanied
by an Externality
An unregulated
competitive market
produces too much of
the externality. In
contrast, the optimal
outcome occurs where
demand equals MTC.
c11RegulationPublicGoodsandBenefitCostAnalysis.qxd 9/29/11 1:34 PM Page 456