ChainWhat it assumes · how to break it
Start
A chemical factory discharges waste into a river, harming fishing businesses and households downstream who play no part in the factory's sales.
1
As a result, the cost of the dirty river is borne by others, so the marginal social cost of production is above the firm's marginal private cost.
external cost · MPC · MSC
external cost · MPC · MSC
Assumes: The firm does not pay for the damage it causes.
But: If the firm can be fined or sued by those harmed, part of the external cost is internalised and MPC moves towards MSC.
2
Since the firm chooses output by comparing its own costs with the price consumers will pay, it ignores the external cost when deciding how much to produce.
self-interest · profit maximisation
self-interest · profit maximisation
Assumes: Firms act only on private costs and revenues.
But: Firms concerned about their reputation with customers and investors may cut pollution voluntarily, so they partly account for the external cost.
3
Consequently, the market price reflects only the private cost, so it is too low to signal the full cost to society and consumers buy more than they would at a price that included the damage.
price mechanism · signalling function
price mechanism · signalling function
Assumes: Price signals private cost only.
But: If demand is price inelastic, a price that included the external cost would cut quantity only a little, so the extra consumption is small.
4
Therefore, output settles at Q1 where MPC = MPB, above the social optimum Q* where MSC = MSB, so too many resources are allocated to producing the good.
overproduction · social optimum
overproduction · social optimum
Best link to attack
Assumes: The external cost rises in step with output.
Assumes: The external cost rises in step with output.
But: If the firm can cut pollution per unit, for example by fitting filters or treating its waste, MSC moves closer to MPC and the gap between Q1 and Q* shrinks without output falling.
End
The good is overproduced: output at Q1 is above the socially optimal level Q*, so too many resources are allocated to it.
Evaluation chain
- E1However, the size of the overproduction depends on how closely pollution is tied to the quantity of output.
- E2If the firm can switch to cleaner technology or treat its waste before discharging it, each unit of output causes less damage.
- E3As a result, the MSC curve moves towards MPC and the socially optimal output Q* moves towards Q1.
- E4So the overallocation of resources depends on the technology used; it is serious where pollution rises with every unit, and small where cleaner production is cheap and available.
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Questions this answers
- Explain why a negative production externality leads to overproduction.
- Using a diagram, analyse why a free market may produce too much of a good that causes pollution.
- Assess whether the market for a polluting good allocates resources efficiently.
Diagram
MPC (supply) and MSC above it, with MPB = MSB (demand): market output Q1 where MPC = MPB, social optimum Q* where MSC = MSB, so Q1 > Q*. Mark the overproduction as the distance Q*Q1 on the quantity axis.
Reverse and related
Positive production externality, e.g. a firm training workers who later move to other firms → MSC below MPC, so the good is underproduced.