Diagram for Negative Externality

Readers Question: Assume that Product X is produced in a perfectly competitive industry and that product X yields costs to individuals who are neither consumers nor producers of Product X.
a) Using one correctly labelled graph, show the industry output and price under each other following conditions.
i) The industry ignores the externality.
ii) The industry produces the socially optimum level of output.

Diagram for Negative Externality


In a free market output is where S (PMC) = D (PMB).  @Q1. In a free market it is assumed that people ignore the external costs. (e.g. when driving you consider the cost of petrol, but, not the fact that congestion and pollution increases causing problems for others.)

Because of externalities such as pollution the social cost of driving is higher than the private cost. Therefore, in a free market we get overconsumption. This makes common sense, just think of rush hour traffic – there tends to be overconsumption of driving because people ignore the costs to others.

Socially efficient level of output.

The socially efficient level of output occurs where the Social marginal cost (SMC) = Social Marginal Benefit (SMB). This occurs at output Q2.

Identify one policy the government might use to achieve the level of output you identified in part (ii)

The easiest policy to achieve output Q2 is using tax. See taxes on negative externality