AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/6/6-2)
Unit 6 · Topic 6.2
6.2 Externalities
An externality is a cost or benefit that falls on people who aren't part of the deal. Negative externalities make markets produce too much, and positive externalities make them produce too little. A per-unit tax or subsidy equal to the external cost or benefit can move the market to the socially optimal quantity.
Key terms
- externality
- marginal social cost
- marginal social benefit
- socially optimal quantity
- Pigouvian tax
- per-unit subsidy
Private versus social
Buyers and sellers look only at their own benefits and costs. Marginal private benefit (MPB) is the buyer's benefit from one more unit, shown by the demand curve. Marginal private cost (MPC) is the seller's cost, shown by the supply curve.
An externality adds a cost or benefit for third parties (people outside the deal). So:
- MSC = MPC + marginal external cost (MEC).
- MSB = MPB + marginal external benefit (MEB).
- The market produces where MPB = MPC. Society wants the quantity where MSB = MSC.
Negative externalities: too much
A factory's smoke harms people downwind, but the factory doesn't pay for it. That harm is an external cost, so MSC is above MPC.
Graph in words: price on the vertical axis, quantity on the horizontal. Draw demand (D = MPB = MSB, assuming no external benefit) and supply (S = MPC). Draw MSC above S; with a constant external cost per unit, it's parallel to S. The market quantity is where S crosses D. The socially optimal quantity is where MSC crosses D, which is smaller, at a higher price.
The market overproduces. Deadweight loss is the triangle between MSC (on top) and D (below), from the socially optimal quantity to the market quantity. Its point is at the optimal quantity.
Externalities can also come from using a good. Secondhand smoke is a negative consumption externality: it puts MSB below the demand curve, and the market again produces too much.
Positive externalities: too little
When you get a flu shot, you're less likely to spread flu to others. They benefit without paying, so MSB is above MPB.
Graph in words: draw demand (D = MPB) and supply (S = MPC = MSC, assuming no external cost). Draw MSB above D. The market quantity is where D crosses S. The socially optimal quantity is where MSB crosses S, which is larger.
The market underproduces. Deadweight loss is the triangle between MSB (on top) and S (below), from the market quantity to the socially optimal quantity. Its point is at the optimal quantity.
Production can create external benefits too. A beekeeper's bees pollinate nearby orchards, which puts MSC below the supply curve, and the market again produces too little.
Fixing externalities
A per-unit tax or subsidy is what changes output, because it changes the cost or benefit of each extra unit. A lump-sum (fixed) tax wouldn't change a firm's output in the short run (6.4).
| Tool | How it works | Used for |
|---|---|---|
| Per-unit (Pigouvian) tax | Tax equal to the external cost per unit shifts supply up to MSC | Negative externalities |
| Per-unit subsidy | Subsidy equal to the external benefit per unit shifts demand up to MSB (or supply down) | Positive externalities |
| Regulation | Limits or standards set the quantity or method directly | Mostly negative externalities |
| Clear property rights | If someone owns the right to clean air or a quiet street, the parties can bargain over it | Either kind, when few people are involved |
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
A negative externality with a corrective tax
In a market for fertilizer, demand (MPB = MSB) runs from $100 at 0 tons and falls $1 per ton. Supply (MPC) starts at $20 and rises $1 per ton. Runoff causes $20 of harm per ton to people downstream. (a) Find the market quantity and price. (b) Find the socially optimal quantity. (c) Find the deadweight loss. (d) What per-unit tax fixes the problem?
Show the solutionHide the solution
- Step 1: (a) Market: MPB = MPC, so 100 − Q = 20 + Q. That gives Q = 40 tons and P = 100 − 40 = $60.
- Step 2: (b) MSC = MPC + $20, which starts at $40 and rises $1 per ton. Optimal: 100 − Q = 40 + Q, so Q = 30 tons, where the price is $70.
- Step 3: (c) At the market quantity of 40 tons, MSC = 40 + 40 = $80 and MSB = $60, a gap of $20. Deadweight loss is the triangle from 30 to 40 tons: ½ × (40 − 30) × 20 = $100.
- Step 4: (d) A per-unit tax of $20 per ton (equal to the external cost) shifts supply up to MSC. The new equilibrium is 30 tons, with buyers paying $70 and sellers keeping $70 − $20 = $50.
Answer: (a) 40 tons at $60. (b) 30 tons. (c) $100. (d) A $20 per-ton tax.
- Example 2Calculator allowed
A positive externality (classic trap: which way to shift)
At a small-town clinic, demand for flu shots (MPB) starts at $60 and falls $1 per shot. Supply (MPC = MSC) starts at $10 and rises $1 per shot. Each shot gives $10 of benefit to other people. A student says the market overproduces because the shots are so popular. (a) Find the market and socially optimal quantities. (b) Find the deadweight loss. (c) What policy fixes it?
Show the solutionHide the solution
- Step 1: (a) Market: 60 − Q = 10 + Q, so Q = 25 shots at a price of $35.
- Step 2: MSB = MPB + $10, starting at $70. Optimal: 70 − Q = 10 + Q, so Q = 30 shots.
- Step 3: The market quantity (25 shots) is below the optimal quantity (30). With a positive externality, the market underproduces, so the student is wrong. Popularity is already in demand; the extra benefit to others isn't.
- Step 4: (b) At 25 shots, MSB = 70 − 25 = $45 and MSC = 10 + 25 = $35, a gap of $10. Deadweight loss = ½ × (30 − 25) × 10 = $25.
- Step 5: (c) A per-unit subsidy of $10 per shot (equal to the external benefit) raises output to 30 shots.
Answer: (a) Market: 25 shots; optimal: 30 shots, so the market underproduces. (b) $25. (c) A $10 per-shot subsidy.
Common mistakes
- Shifting the demand curve for a negative production externality. The external cost belongs on the cost side: draw MSC above supply.
- Saying the market produces too little with a negative externality. Ignoring a cost makes the good look cheaper than it is, so the market makes too much.
- Taxing a good with a positive externality. Positive externalities call for a subsidy; a tax would make the underproduction worse.
- Drawing the deadweight loss triangle pointing toward the market quantity. Its point is at the socially optimal quantity, and its base is at the market quantity.
On the exam
- Expect to describe an externality graph with MPB, MPC and either MSC or MSB, identify the market and socially optimal quantities, and identify the deadweight loss. Then you may be asked which per-unit tax or subsidy fixes it, and what it does to price and quantity.
- If a question asks for the size of the corrective tax, the answer is the marginal external cost at the optimal quantity, which equals the vertical gap between MSC and MPC.
Connected topics
Videos
Check yourself
5 questions on 6.2 Externalities. Pick an answer to see if you got it, and why.
| Quantity (hundreds of shots) | Marginal private benefit | Marginal social benefit | Marginal cost |
|---|---|---|---|
| 1 | $16 | $20 | $4 |
| 2 | $14 | $18 | $6 |
| 3 | $12 | $16 | $8 |
| 4 | $10 | $14 | $10 |
| 5 | $8 | $12 | $12 |
| 6 | $6 | $10 | $14 |
Hypothetical data for flu shots sold in a perfectly competitive market. Each shot also protects people who don't get one, so marginal social benefit is higher than the buyer's own benefit. There are no external costs. Benefits and costs are per shot.
How many flu shots will the unregulated market provide?
What is the socially optimal number of flu shots?
Which per-unit subsidy would lead the market to the socially optimal quantity?
Without government action, the market for flu shots will
Instead of subsidizing buyers, the government could reach the socially optimal quantity by
0 of 5 answered