In this article we will discuss about how negative externality becomes a source of economic inefficiency.
Suppose John an ambitious rock musician, resort to the practice of playing electronic guitar, every day for five hours in his house.
However John’s immediate neighbor, Peter does not enjoy listing to the ear-storming guitar notes. The practice time of John differs from socially efficient time. In this case, the musician John determines the practice time per day, considering the cost benefit of that activity to him.
Benefit calculation includes, future wealth, reputation flowing from his musical performance determined by the present hours of practice done.
On the cost side include the opportunity cost of utilizing the time for some other paid job, money needed for the purchase of guitar and auxiliary instruments needed for the conduct of music by musicians. In addition to this, there is an external cost in the form of the discomfort caused to Peter on account of Johns practice per day. The bye-product of the musician’s activity is noise pollution.
Air is a resources used in the production of practice time. However John does not pay for the air space he uses, air being a common property. Here a divergence between private and social costs emerges. The full cost of producing a product such as practice time, is not fully considered by the producer. In this example the difference between private and social cost is the disutility that John imposes on Peter.
This difference measures the extent of negative externality or external cost, for which the producer is not charged. Peter losses fresh air space, silent sleep and a lower common property. The market system fails to take care for negative externality.
Figure No. 2.2 shows marginal social Benefits (MSB) Marginal private opportunity costs (MPC) and Marginal social opportunity costs (MSC) for Johns practice time. Marginal benefits and demand curves are identical; likewise marginal costs and supply curves.
Since there are two cost curves, we have two supply curves. PS is private costs and SS is social costs. When John does not pay for the costs inflicted on peter, total net benefit are maximize at T1, where MSB = MPC. It is assumed that air space has many alternative uses- like listening to classical music or sleeping silently etc.
Hence at point T, the air space is efficiently allocated from John’s point of view. However it is not an efficient allocation for the society composed of John and Peter.
The MSC of practice time is constructed by adding the value of air space plus, MPC. The value of the air space in the next best uses measures the opportunity cost of that resource.
The difference between MSC and MPC is distance ‘be’ per unit. It measures the size of negative externality. Allocative efficiency occurs at practice time T2, where net social benefits are maximized.
MSB = MSC
At the private market output of T1, net social benefits are not maximized because MSB < MSC (i.e. C < b). In this case, too many resources are devoted to practicing guitar.
Distance T2 T1 is the amount by which John practices too much when he does not pay for the air space he uses.
Private markets allocate resources efficiency when prices are equal to marginal social costs and marginal social benefits. From the figure it is clear that market prices are determined by the interaction of marginal social benefits and marginal cost curves. But when the MPC and MSC curves diverge, there are two supply curves.
Supply PS did not reflect the externality but supply SS does. When externality is not included in the cost of production, Price P1 is placed on practice activity, and P = MSB = MPC < MSC. Therefore market price P1 is set below MSC and is therefore inconsistent with maximizing total net benefit of society.
When externalities are reflected in costs, P = MSB = MSC > MPC. In this condition market price P2 achieves Allocative efficiency because marginal social benefits are equal to marginal social costs. Therefore by reducing time spent in practice from T1 to T2, area ‘abc’ is equal to the rise in net social benefits that results when the market fully accounts for costs of all resources used in the market.