Principles of Microeconomics / Unit 17 MIC 1636 worked example, 60 to 90 seconds
Sample Question Seven: A Negative Externality
The idea
When production harms a third party, the seller's marginal private cost leaves the damage out, and marginal social cost lies above it by the external cost. The market clears where demand meets private cost; the optimum is where demand meets social cost, at a smaller quantity. So the market overproduces; the exam's answer is that marginal social cost exceeds marginal private cost and output is above the efficient level. A tax equal to the external cost per unit shifts supply up to social cost and moves the market to the optimum.
In practice
Worked example: buyers take ten thousand units at five dollars, eight thousand at six and six thousand at seven; private supply offers six thousand at five, eight thousand at six and ten thousand at seven. The market clears at six dollars and eight thousand. Each unit does two dollars of damage, so social supply offers six thousand at seven and eight thousand at eight; demand meets it at seven dollars and six thousand. The market makes two thousand too many at a dollar too little, and a two-dollar tax per unit corrects it exactly.
Where people slip
Overproduction, not underproduction, is the negative case; the mirror, a positive externality, underproduces. And the optimum is six thousand, not zero; the efficient quantity of a harmful good is where its value to buyers covers its full cost, and some damage remains.
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