2.8.2—Externalities and welfare loss

An externality is an uncompensated cost or benefit affecting a third party. The market quantity differs from the social optimum because decision-makers use private rather than social marginal costs or benefits.

Negative production: $MSC>MPC$, causing overproduction. Negative consumption: $MSB<MPB$, causing overconsumption. Positive production: $MSC<MPC$, causing underproduction. Positive consumption: $MSB>MPB$, causing underconsumption. Welfare loss lies between the relevant social curves over the misallocated units.

First identify production versus consumption and cost versus benefit; then choose which marginal curve separates, mark market and social quantities, and shade the welfare-loss region with arrows toward the efficient quantity.

Factory pollution is a negative production externality, so supply based on $MPC$ gives output above the $MSB=MSC$ optimum. Vaccination benefits others through consumption, so demand based on $MPB$ gives output below the optimum.

Merit goods are judged socially under-consumed and commonly linked to positive consumption externalities; demerit goods are judged over-consumed and commonly linked to negative consumption externalities. These judgments also involve information and values.