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Econ 101: Negative Externality

Consider the standard demand and supply diagram with pollution (click on the thumbnail to the right for a bigger image). An unregulated market leads to equilibrium price and quantity determined at the intersection of the supply, or marginal private cost (MPC), curve and the demand curve: P1, Q1.

Consumers and producers enjoy the gains from this equilibrium. The consumer surplus is the difference between willingness to pay (height of the demand curve) and price: area a + b + c + d. You enjoy consumer surplus every time you buy something and get a "good deal."

The producer surplus is the difference between the revenue earned on each unit (P1) and its marginal cost of production: area f + g + h (note that f includes the tiny triangle below P1 and above the MSC curve). Producer surplus is equivalent to profit without the fixed cost (e.g., monthly lease payments that don't change with output).

Unfortunately, production of Q generates some harmful side (i.e., external) effects such as fewer healthy days, fewer recreation opportunities, etc: marginal external cost = MEC. If these costs are constant then the full costs to society of production of Q is the marginal social cost curve: MSC = MPC + MEC. The external costs of Q1 are equal to area c + d + e + f + g + h. (Nothing in the conclusions changes if the MEC is increasing in Q0.

Environmental regulation is designed to get firms to "internalize the externality" by considering the external costs of production. If firms face a constant pollution tax on each unit of output so that they face production costs equivalent to the MSC curve then the new market equilibrium will be P2, Q2. The regulated product market will have a higher price and lower quantity.

At the new equilibrium, consumer surplus is area a and producer surplus is h. Government revenue is area b + c + f. The deadweight loss (DWL) of the tax is d + g (poof!). However, the avoided external cost is equal to d + e + g. Therefore, the net benefit...