Profit-maximizing perfectly competitive firms will produce output up to the point at which price is equal to marginal cost (P = MC). As a result, competitive markets produce and efficient mix of output.
But if the production of the firms product imposes external costs on society, producing at that point will not be efficient. If the firm does not take those additional costs into account, it is likely to overproduce. This is illustrated Figure 14.1.
The top two panels of the figure illustrate the perfectly competitive firm in a situation where there are no externalities. Production at q* is efficient.
In the lower two panels, external costs have been included, but the firm is ignoring them. The curve labeled MSC, marginal social cost, is the sum of the marginal costs of producing the product (MC) plus the correctly measured damage costs imposed in the process of production. Production at q* is no longer efficient.
Acid Rain and the Clean Air Act
Acid rain is an excellent example of an externality and the issues and conflicts in dealing with externalities. Manufacturing firms and power plants in the Midwest burn coal with high sulfur content. When the smoke from these plants mixes with moisture in the atmosphere, the result is a dilute acid that is windblown north to Canada and east to New York and New England, where it falls to earth in the rain. The acid rain imposes enormous costs where it falls; estimates of damage from fish kills, building deterioration, and deforestation range into the billions of dollars.
But if the power plants were forced to consider these costs, electric bills would rise in the Midwest, which would raise production costs and perhaps result in a loss of jobs.
The case of acid rain highlights the fact that efficiency analysis ignores the distribution of gains and losses. To establish efficiency, we need only to demonstrate that the total value of the gains exceeds the total value of the losses.
After many years of debate, Congress passed and President Bush signed the Clean Air Act of 1990, which includes strict air emissions standards and uses tradable pollution rights (to be discussed later in this chapter).
Not all externalities are negative. Restoring an abandoned house in an urban neighborhood makes the area better and adds value to the neighbors homes.