If we assume
that the producer is interested in maximising
profits - then they will only take into account the private costs and private
benefits arising from their supply of the product. We can see from the
diagram below that the profit-maximising level of output is at Q1. However
the socially efficient level of
production would consider the external
costs too. The social optimum
output level is lower at Q2.
This leads to
the private optimum output being greater than the social optimum level of
production. The producer creating the externality does not take the effects
of externalities into their own calculations. We assume that producers are
only concerned with their own self interest.
In the diagram
above, the private optimum output is when where private marginal benefit =
private marginal cost, giving an output of Q1. For society as a whole though
the social optimum is where social marginal benefit = social marginal cost at
output Q2.The failure to take into account the negative externality effects
is an example of market failure.
This leads to the good or service being over-produced relative to the