efficient solution would be at the point where
MB(Q) = MSC(Q).
Thus the free competitive market leads to the
excessive
negative externality causing activities.
8
Inefficiency of Competition with
Externality

This
** preview**
has intentionally

**sections.**

*blurred***to view the full version.**

*Sign up*
Market Solution Vs. Optimal Solution
Q
0
MB, MD
Q
MARKET
D = MB
MC
Q
OPT
Optimal Solution
9
Market eqlbm
MSC = MC+MEC
A
B
B D
H
G
F
E
Results:
1.
Q
market
> Q
optimal
2.
Q
optimal
> 0.

Welfare Analysis
Competitive Market Solution
: MB(Q) = MC(Q)
Consumer Surplus, CS = A+B+C+D
Producer Surplus, PS = F+G+H
Harm to the environment, EC = C+D+H+G+E
Total Surplus = CS+PS- EC = A+B+F-E
Optimal Solution:
MB(Q) = MSC(Q)
CS = A
PS = B+C+F+G
EC = G+C
Total Surplus = A+B+F
Thus
DWL = TS (optimal)
–
TS(market) = E
10

This
** preview**
has intentionally

**sections.**

*blurred***to view the full version.**

*Sign up*
Policy Solutions
Pigouvian Taxes or subsidies
The government can solve the problem caused by a
negative externality by imposing a Pigovian tax (
t =
MEC at Q
opt
) on the producer (or consumer).
This tax (on producer) will increase the MC of
production of the factory by the tax amount and as
a result shifts the MC of production (after tax) to
the left by the tax amount.
This tax induces the producer to reduce the
equilibrium quantity to Q
optimal
, and thus eliminates
the DWL.
11