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Suppose that there are two people who live in a dormitory, Harry (who has a really expensive stereo system) and Jake (who lives next door to Harry). Harry (who has impaired hearing) plays his favorite music very loud, and Jake can hear it through the very thin walls. Jake doesn’t like the same music as Harry, anyway. If we assume that there are no further external costs or benefits to anyone other than these two individuals, the figure below illustrates the decision process that they face.
Harry’s marginal benefits and marginal cost curves are shown in blue (his MPC would reflect the cost of electricity, for example) and the red curves are the marginal damage cost to Jake (the loud music affects him negatively) and the marginal social cost (found by adding Harry’s marginal cost to the marginal damage cost). If Harry considers only his private costs, he will play his stereo for a number of hours that is inefficient from the society’s point of view. It is generally true that when economic decisions ignore external costs, whether those costs are borne by one person or by society, those decisions are likely to be inefficient.
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