(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 687

662 PART 4 • Information, Market Failure, and the Role of Government
• externality Action by either
a producer or a consumer which
affects other producers or
consumers, but is not accounted
for in the market price.

daily catch. The more waste the steel plant dumps in the river, the fewer fish
will be supported. The firm, however, has no incentive to account for the external costs that it imposes on fishermen when making its production decision.
Furthermore, there is no market in which these external costs can be reflected in
the price of steel. A positive externality occurs when a home owner repaints her
house and plants an attractive garden. All the neighbors benefit from this activity, even though the home owner’s decision to repaint and landscape probably
did not take these benefits into account.

Negative Externalities and Inefficiency
In §6.3, we explain that with
a fixed-proportions production function, it is impossible
to substitute among inputs
because each level of output
requires a specific combination of labor and capital.

Because externalities are not reflected in market prices, they can be a source of
economic inefficiency. When firms do not take into account the harms associated with negative externalities, the result is excess production and unnecessary
social costs. To see why, let’s take our example of a steel plant dumping waste in
a river. Figure 18.1 (a) shows the production decision of a steel plant in a competitive market. Figure 18.1 (b) shows the market demand and supply curves,
assuming that all steel plants generate similar externalities. We assume that
because the firm has a fixed-proportions production function, it cannot alter its
input combinations; waste and other effluent can be reduced only by lowering output. (Without this assumption, firms would be jointly choosing among
a variety of combinations of output and pollution abatement.) We will analyze
the nature of the externality under two circumstances: first when only one steel
plant pollutes and, second, when all steel plants pollute in the same way.

Price

MSC

Price

MC
MSC I
S ϭ MC I

P*
P1

P1
MEC I
MEC
D
Firm output

q* q 1
(a)

Q*

Q1

Industry output
(b)

F IGURE 18.1

EXTERNAL COST
When there are negative externalities, the marginal social cost MSC is higher than the marginal cost MC.
The difference is the marginal external cost MEC. In (a), a profit-maximizing firm produces at q1, where price is equal
to MC. The efficient output is q*, at which price equals MSC. In (b), the industry’s competitive output is Q1, at the
intersection of industry supply MCI and demand D. However, the efficient output Q* is lower, at the intersection of
demand and marginal social cost MSCI.