Externality Lab

When making or using a good affects people outside the sale, the market leaves that cost or benefit out. Buyers and sellers stop where marginal private benefit equals marginal private cost (MPB = MPC); society is best off where marginal social benefit equals marginal social cost (MSB = MSC). The gap between the two quantities is a deadweight loss, and a tax or subsidy equal to the external cost or benefit per unit closes it.

How this lab works

Explore: pick one of the four externalities and drag the size of the external cost or benefit. The graph marks the market point and the efficient point (E*) and shades the deadweight loss, a triangle that points toward the efficient quantity. Then move the corrective tax or subsidy: the private curve shifts toward the social one, the shaded loss shrinks, and it vanishes when the tax or subsidy equals the external cost or benefit per unit. Go past it and a new loss opens on the other side. Public goods shows why a park or streetlights are underprovided: everyone benefits from the same unit, so the social benefit is the sum of everyone's benefit, while each person alone buys almost none (the free rider).

Test yourself: name the externality, place the efficient point, shade and measure the deadweight loss, choose and size the corrective policy and draw it, and find the efficient amount of a public good. A wrong answer names the slip, such as market and efficient quantities swapped, the whole external cost shaded instead of the triangle, or one person's benefit used for a public good.

On the graph each step is a fixed number of units and dollars, stated in each problem.

Notes for this topic: Externalities