Externalities: Private Cost versus Social Cost

Why a free market can fail

A competitive market maximises total surplus only when the people trading bear all the costs and receive all the benefits. An externality exists when a cost or benefit spills over onto a third party who is neither the buyer nor the seller.

Four curves matter, and the exam expects the abbreviations:

• MPC — marginal private cost, what the producer pays. This is the supply curve.
• MSC — marginal social cost, $\text{MSC}=\text{MPC}+\text{MEC}$, where MEC is the marginal external cost.
• MPB — marginal private benefit, what the buyer gets. This is the demand curve.
• MSB — marginal social benefit, $\text{MSB}=\text{MPB}+\text{MEB}$.

With a negative externality in production — a factory dumping smoke — the external cost falls on society, so $\text{MSC}>\text{MPC}$. The market clears where $\text{MPC}=\text{MPB}$, but efficiency requires $\text{MSC}=\text{MSB}$. Because MSC lies above MPC, the market quantity is larger than the socially optimal quantity: the market overproduces, and the units between $Q^*$ and $Q_{market}$ cost society more than they are worth. That wedge is the deadweight loss.

Positive externalities

A positive externality is a benefit that spills over to third parties. Vaccination, education and beekeeping next to an orchard are the standard cases. Here $\text{MSB}>\text{MPB}$: the person deciding whether to get vaccinated counts only her own protection, not the protection she gives everyone she would have infected.

Because the buyer values only the private slice of the benefit, demand sits below the true social benefit curve. The market equilibrium therefore occurs at a quantity smaller than $Q^*$: the market underproduces, and deadweight loss appears again — this time made of units that should have been produced but were not.

Two traps. First, a positive externality still produces a deadweight loss; "positive" does not mean "efficient". Second, the externality can sit on either side of the market. A negative externality in consumption (second-hand smoke) shifts MSB below MPB, not MSC above MPC — the diagram changes, but the conclusion that the market overproduces does not.