An externality arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. If the impact on the bystander is adverse, it is called a negative externality; if it is beneficial, it is called a positive externality.
Now let’s suppose that aluminum factories emit pollution: For each unit of aluminum produced, a certain amount of smoke enters the atmosphere. Because this smoke creates a health risk for those who breathe the air, it is a negative externality.
How does this externality affect the efficiency of the market outcome? Due to the externality, the cost to society of producing aluminum is larger than the cost to the aluminum producers. For each unit of aluminum produced, the social cost includes the private costs of the aluminum producers plus the costs to those bystanders adversely affected by the pollution. The social-cost curve is above the supply curve because it takes into account the external costs imposed on society by aluminum producers. The difference between these two curves reflects the cost of the pollution emitted.
What quantity of aluminum should be produced?
To answer this question, we once again consider what a benevolent social planner would do. The planner wants to maximize the total surplus derived from the market—the value to consumers of aluminum minus the cost of producing aluminum. The planner understands, however, that the cost of producing aluminum includes the external costs of the pollution.
The planner would choose the level of aluminum production at which the demand curve crosses the social-cost curve. This intersection determines the optimal amount of aluminum from the standpoint of society as a whole. Below this level of production, the value of the aluminum to consumers exceeds the social cost of producing it (as measured by the height of the social-cost curve). The planner does not produce more than this level because the social
cost of producing additional aluminum exceeds the value to consumers.
Note that the equilibrium quantity of aluminum, QMARKET, is larger than the socially optimal quantity, QOPTIMUM. The reason for this inefficiency is that the market equilibrium reflects only the private costs of production. In the market equilibrium, the marginal consumer values aluminum at less than the social cost of producing it. That is, at QMARKET the demand curve lies below the social-cost curve. Thus, reducing aluminum production and consumption below the market equilibrium level raises total economic well-being.
How can the social planner achieve the optimal outcome?
One way would be to tax aluminum producers for each ton of aluminum sold. The tax would shift the supply curve for aluminum upward by the size of the tax. If the tax accurately reflected the social cost of smoke released into the atmosphere, the new supply curve would coincide with the social-cost curve. In the new market equilibrium, aluminum producers would produce the socially optimal quantity of aluminum.