[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

was explained in Chapter 11, the extra costs and benefits not captured by the market
transaction are called externalities.
Externalities can be either positive or negative, depending on whether individuals
enjoy extra benefits they did not pay for or suffer extra costs they did not incur
themselves. Goods for which there are positive externalities—such as research and
development—will be undersupplied in the market (see Chapter 20). In deciding
how much of the good to purchase, each individual or firm thinks only about the
benefits it receives, not the benefits conferred on others. By the same token, goods
for which there are negative externalities, such as air and water pollution, will be
over-supplied in the market. The inability of the market to fully capture the
costs and benefits of a trade provides a classic example of a market failure and a
possible role for the public sector.
Figure 18.1A shows the demand and supply curves for a good—say, steel. Market
equilibrium is the intersection of the curves, the point labeled E, with output Q p and
price p p . Chapter 10 explained why, in the absence of externalities, the equilibrium
E is efficient. The price reflects the marginal benefit that individuals receive from
an extra unit of steel (it measures their marginal willingness to pay for an extra
unit). The price also reflects the marginal cost to the firm of producing an
extra unit. At E, marginal benefits equal marginal costs.
A
B
Market supply curve
(the marginal cost of
producing steel)
Social marginal
cost of producing
steel
PRICE OF STEEL (p )
p p
E
Market demand curve
(the marginal benefit
of consuming steel)
PRICE OF STEEL (p )
p s
p p
Private marginal
cost of
producing steel
(market supply)
Market demand curve
(marginal benefit of
consuming steel)
Q p
Q s
Q p
QUANTITY OF STEEL (Q )
QUANTITY OF STEEL (Q )
Figure 18.1
HOW NEGATIVE EXTERNALITIES
CAUSE OVERSUPPLY
In a perfectly competitive market, the market supply curve is the (horizontal) sum of the
marginal cost curves of all firms, while market demand reflects how much the marginal
unit is worth to any consumer. In panel A, the equilibrium, at quantity Q p and price p p ,
will be where private marginal cost is equal to the marginal benefit.
If society as a whole faces broader costs, like pollution, then the social marginal costs
will exceed the private costs. If the supplier is not required to take these additional costs
into account (as in panel B), production will be at Q p , and the quantity produced will
exceed the amount Q s where marginal cost is equal to marginal benefit for society
as a whole.
406 ∂ CHAPTER 18 ENVIRONMENTAL ECONOMICS