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, the market produces at Q1 where MPC = MPB, beyond the social optimum Q* where MSC = MSB.
overproduction · social optimum
overproduction · social optimum
Assumes: Nothing corrects the externality.
But: Emission limits, or a tax equal to the marginal external cost, can move output towards Q*.
5
This means on each unit between Q* and Q1 the marginal social cost is greater than the marginal social benefit, so every one of these units makes society worse off and the total of these losses is a deadweight welfare loss.
deadweight welfare loss · allocative inefficiency (MSC > MSB)
deadweight welfare loss · allocative inefficiency (MSC > MSB)
Best link to attack
Assumes: The external cost can be valued accurately in money.
Assumes: The external cost can be valued accurately in money.
But: Damage such as harm to health or wildlife is very hard to value, so the true gap between MSC and MSB, and so the size of the welfare loss, is uncertain.
End
Overproduction causes a deadweight welfare loss: resources are allocated inefficiently because MSC exceeds MSB on the units between Q* and Q1.
Evaluation chain
- E1However, the size of the welfare loss depends on how accurately the external cost can be measured.
- E2Because harms such as illness, lost fish stocks or damage to wildlife have no market price, economists must estimate them, and estimates vary widely.
- E3As a result, the true positions of MSC and Q* are uncertain, so the welfare loss triangle may be much larger or smaller than drawn.
- E4So the welfare loss is real, but its size depends on how the damage is valued, and a tax set on a poor estimate may leave a welfare loss or even create one.
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Questions this answers
- Using a diagram, explain why a negative production externality causes a welfare loss.
- Explain why a market with pollution is allocatively inefficient.
- Assess the extent to which pollution from production leads to a loss of economic welfare.
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*. Shade the welfare loss triangle between MSC and MSB from Q* to Q1, with its point at Q*.
Reverse and related
Positive production externality → MSC below MPC, underproduction, and a welfare loss on the units between Q1 and Q* that are not produced.