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3 Externalities in supply and demand
The usual economic analysis of externalities can be illustrated using a standard supply and demandsupply and demand model describes how prices vary as a result of a balance between product availability and demand. The graph depicts an increase in demand from D to D along with the consequent increase in price and quantity required to reach a new equili diagram if the externality can be monetized (valued in terms of money). An extra supply or demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers pay as individuals for additional quantities of the good (in competitive markets, the marginal private cost) and the other curve is the true cost that society as a whole pays for production and consumption of increased production the good (the marginal social cost).
Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demandEffective demand (in macroeconomics often seen as synonymous with " aggregate demand"), refers to the very simple economic idea that says that it's not enough to want something such as food or luxuries. One must also have money or other assets (purchasing in the market.
3.1 Negative externalities
The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market -- before pollution-control laws were imposed and enforced (e.g., under laissez faire). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of the smoking stacks and water pollution. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.
If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered marketA free market economy is an idealized form of market economy in which buyers and sellers are permitted to carry out transactions based solely on mutual agreement without interventionism in the form of taxes, subsidies, regulation, or government provision is inefficient since at the quantity Qp, the social benefit is less than the societal cost, so society as a whole would be better off if the goods between Qp and Qs had not been produced. The problem is that people are buying and consuming too much steel.
This discussion implies that pollution is more than merely an ethical problem; it is more than just "greedy" ( profitProfit is what is gained, after costs are accounted for. In accounting, this is usually measured in monetary terms. In economics, profit is most often measured differently, since costs are opportunity costs. Profit is income received by buying low and sel-maximizing) firms. The problem is one of the disjuncture between marginal and social costs that is not solved by the free marketA free market economy is an idealized form of market economy in which buyers and sellers are permitted to carry out transactions based solely on mutual agreement without interventionism in the form of taxes, subsidies, regulation, or government provision. There is a problem of societal communication and coordination to balance benefits and costs. This discussion also implies that pollution is not something solved by competitive markets. In fact, a monopoly might be able to use some of its excess profits to be benevolent and internalize the externality (pay the cost of the pollution). More likely, a monopoly would artificially restrict the quantity supplied in order to maximize profits. This would actually benefit society in this situation because it would mean less pollution than in the competitive case. Perfectly competitive firms have no choice but to produce according to market incentives (private costs): if one decides to internalize external costs, it implies higher costs than those of competitors and likely exit from the market. So some collective solution is needed, e.g., some sort of government program to ban or discourage pollution.
