Externalities
Market inefficiency from positive and negative externalities.
What this graph shows
This sandbox shows what happens when a market ignores costs or benefits that fall on people outside the transaction. In negative mode, the red private supply curve is marginal private cost (MPC), and the orange dashed curve sits above it as marginal social cost (MSC), adding the pollution or spillover cost that firms do not pay. In positive mode, the blue private demand curve is marginal private benefit (MPB), and the green dashed curve sits above it as marginal social benefit (MSB), adding the spillover value that buyers do not capture.
Because private decision-makers weigh only their own costs and benefits, the market equilibrium lands at the wrong quantity: a negative externality produces too much, a positive externality too little. The yellow triangle marks the deadweight loss (DWL), the value society loses at the market quantity relative to the socially optimal quantity where the dashed social curve crosses the private curve on the other side. A Pigouvian tax (negative case) or subsidy (positive case) shifts the private curve onto the social curve, moving the market to the optimum and erasing the DWL.
How to read it
Price sits on the vertical axis and quantity on the horizontal. The solid curves are private (what firms and buyers respond to) and the dashed curve is social. Find the private equilibrium E where solid supply and demand cross, and the social optimum E* where the dashed social curve crosses the other private curve. The horizontal gap between those quantities is the over- or under-production, and the yellow triangle between them is the deadweight loss. The stats strip reports the market price, the optimal price, and the DWL, which drops to zero once you apply the corrective tax or subsidy.
Three things to try
- In negative mode, drag the External Cost slider from 0 up to 40 and watch the orange MSC curve pull further above supply while the yellow deadweight-loss triangle grows, showing that bigger spillovers mean bigger overproduction.
- With a large external cost set, click Apply Pigouvian Tax and confirm the supply curve jumps up onto the MSC line, the equilibrium slides left to the optimal quantity, and the DWL readout falls to $0.
- Switch to Positive mode, raise the External Benefit slider, and notice the market now sits to the LEFT of the optimum (underproduction), then apply the Pigouvian subsidy to shift demand up to MSB and close the gap.
Common questions
Why does a negative externality cause overproduction instead of underproduction?
Firms base output on their private costs (MPC) and ignore the extra cost imposed on society (MSC). Since they act as if production is cheaper than it truly is, they push output past the socially optimal quantity, where MSC would equal marginal social benefit.
What is the difference between MPC and MSC on this graph?
MPC is marginal private cost, the red solid supply curve reflecting only what the firm pays. MSC is marginal social cost, the orange dashed curve, equal to MPC plus the external cost. The vertical gap between them is the size of the externality per unit.
How does a Pigouvian tax eliminate the deadweight loss?
A Pigouvian tax equal to the external cost per unit raises private supply until it lines up exactly with MSC. The market then chooses the quantity where MSC meets demand, which is the social optimum, so the deadweight-loss triangle disappears.
Externalities: key terms
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