Negative Production Externalities

• • Producers maximise private benefit by producing an output of Q1, where MPC = MPB.
• • However, the socially optimal level of output is at Q2, where MSC = MSB.
• • This tells us that market forces are over-producing electricity, shown by the difference between Q2 and Q1, which is why the market fails - the wrong quantity is provided. At the free-market price of P1, electricity is too cheap. Prices have to rise to P2 to bring about the socially optimal level of consumption
• • The shaded area represents the DWL, which is exists at the privately optimal output of Q1, all the way back to the socially optimal level of Q2. This is because for units Q1 to Q2, the social cost of producing each unit (of electricity) is greater than the benefit society derives from each unit produced (MSC > MSB).
• • When producers limit production and remove units Q1 to Q2, DWL is eliminated as production takes place at the socially optimal level of output.