(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 688

CHAPTER 18 • Externalities and Public Goods 663

The price of steel is P1 at the intersection of the demand and supply curves
in Figure 18.1 (b). The MC curve in (a) gives a typical steel firm’s marginal cost
of production. The firm maximizes profit by producing output q1, at which
marginal cost is equal to price (which equals marginal revenue because the firm
takes price as given). As the firm’s output changes, however, the external cost
imposed on fishermen downstream also changes. This external cost is given
by the marginal external cost (MEC) curve in Figure 18.1 (a). It is intuitively
clear why total external cost increases with output—there is more pollution.
However, our analysis focuses on the marginal external cost, which measures
the added cost of the externality associated with each additional unit of output
produced. In practice, the MEC curve is upward sloping for most forms of pollution: As the firm produces additional output and dumps additional effluent,
the incremental harm to the fishing industry increases.
From a social point of view, the firm produces too much output. The efficient
level of output is the level at which the price of the product is equal to the marginal social cost (MSC) of production: the marginal cost of production plus the
marginal external cost of dumping effluent. In Figure 18.1 (a), the marginal social
cost curve is obtained by adding marginal cost and marginal external cost for each
level of output (i.e., MSC = MC + MEC). The marginal social cost curve MSC
intersects the price line at output q*. Because only one plant is dumping effluent
into the river, the market price of the product is unchanged. However, the firm is
producing too much output (q1 instead of q*) and generating too much effluent.
Now consider what happens when all steel plants dump their effluent into
rivers. In Figure 18.1 (b), the MCI curve is the industry supply curve. The marginal external cost associated with the industry output, MEC I, is obtained by
summing the marginal cost of every person harmed at each level of output. The
MSCI curve represents the sum of the marginal cost of production and the marginal external cost for all steel firms. As a result, MSCI = MCI + MECI.
Is industry output efficient when there are externalities? As Figure 18.1
(b) shows, the efficient industry output level is the level at which the marginal benefit of an additional unit of output is equal to the marginal social
cost. Because the demand curve measures the marginal benefit to consumers,
the efficient output is Q*, at the intersection of the marginal social cost MSCI
and demand D curves. The competitive industry output, however, is at Q1, the

intersection of the demand curve and the supply curve, MCI. Clearly, industry
output is too high.
In our example, each unit of output results in some effluent being dumped.
Therefore, whether we are looking at one firm’s pollution or the entire industry’s, the economic inefficiency is the excess production that results in too much
effluent being dumped in the river. The source of the inefficiency is the incorrect pricing of the product. The market price P1 in Figure 18.1 (b) is too low—
it reflects the firms’ marginal private cost of production, but not the marginal
social cost. Only at the higher price P* will steel firms produce the efficient level
of output.
What is the cost to society of this inefficiency? For each unit produced above
Q*, the social cost is given by the difference between the marginal social cost
and the marginal benefit (the demand curve). As a result, the aggregate social
cost is shown in Figure 18.1 (b) as the shaded triangle between MSC I, D, and
output Q1. When we move from the profit-maximizing to the socially efficient
output, firms are worse off because their profits are reduced, and purchasers of
steel are worse off because the price of steel has increased. However, these losses
are less than the gain to those who were harmed by the adverse effect of the
dumping of effluent in the river.

In §8.3, we explain that
because a competitive firm
faces a horizontal demand
curve, choosing its output so
that marginal cost is equal to
price is profit-maximizing.
• marginal external cost
Increase in cost imposed
externally as one or more firms
increase output by one unit.

• marginal social cost Sum of

the marginal cost of production
and the marginal external cost.

In §9.2, we explain that,
absent market failure, a
competitive market leads to
the economically efficient
output level.