The market for lumber is perfectly competitive
● No barriers of entry, zero profit
● Lumber mills dump toxins into adjourning lakes, thereby reducing the recreational value
of the lakes
○ less enjoyment of the lake
● Lumber mills are not required to compensate users of the lakes (or cottage owners) for
the decline in recreational quality(value) of the lakes.
● Will the price paid by consumer for lumber be
○ too high?
○ too low?
○ just right?
● Why? - The cost of the pollutants (toxins) is not reflected in the market price of lumber.
● Will the market for lumber produce an allocationally efficient level of output. - No.
○ The point where price (value to the buyer) = marginal cost (cost for the producer
to produce the last unit sold).
○ the marginal cost has to reflect both the total cost and the social cost.
● Externality: Transaction between buyer and seller affects third party.
○ Pollution: production externality
○ Alcohol: consumption externality
○ Can be positive or negative
● When the product is made vs. when the product is bought
○ Where does the problem lie?
● In general, market outcome is not efficient (“market failure”) and government intervention
can improve market outcome.
● If there is an externality in a perfectly competitive market, the outcome will not be
○ Too many firms, cannot negotiate
○ Single firm cannot influence price. ● Allocative efficiency (no externalities) P=MC
● If third parties are affected (“externality”) competitive outcome is not allocatively efficient
○ Important examples: pollution
2. Pollution: Negative Externality of Production
● Market: Aluminum
● External cost: Smoke ($10 per Tonne)
Price (Per Tonne) Quantity Demanded Quantity supplied Quantity supplied
(After $10 tax)
15 80 40 20
20 70 50 30
25 60 60 40
30 50 70 50
35 40 80 60
40 30 90 70