Socially efficient and inefficient outcomes

Let's study the market for soda a little bit. So, we're going to draw our traditional axes. So that is price, and that is quantity. We have seen our classic supply and demand curves. So, this could be our upward sloping supply curve. At a low price, not a lot of people want to produce soda. But as price goes higher, more and more people would want to produce it.

We could also view that as a marginal cost curve. That first unit might be quite easy to produce, but then it gets a little bit more and more expensive or costly to produce, as you have to hire and train more people and get real estate for your factories. So, you could also view this as a marginal cost curve.

On the demand side, we have our classic downward sloping curve. At a high price, not a lot of people are going to want the soda. But then as price gets lower, a lot more people are going to want the soda. So, this is our demand curve, which we could also view as a marginal benefit curve. That first unit of soda, a lot of someone's going to get a huge benefit for it, and so they have a high willingness to pay.

Then, every incremental unit, people might just get a little bit less benefit, and so they have a little bit less willingness to pay, which makes us downward sloping. So, we have this; we could also use the marginal benefit curve. We have this as all review. You would have your equilibrium quantity that the market would produce and the equilibrium price.

But now, I'm going to introduce a new idea. Because everything we talked about here, the marginal benefit and the cost, this was just the marginal private benefit and the marginal private cost. It's not factoring in society's benefits and costs. So, let me re-label this a little bit. Instead of just saying marginal benefit, I'm going to call this the marginal private benefit. Instead of marginal cost, I'm going to call this the marginal private cost.

This is the equilibrium price we would get to if we just factored in the private costs and benefits. This is the equilibrium quantity if we just factored in the private costs and benefits. So, I know what you're thinking, "So that's nice, Sal, but how do we factor in the social benefits or costs?"

Well, for something like soda, you could have some negative social costs. When you have negative social costs, you would call that a negative externality. So, there are some negative externalities when you are thinking about soda. It could be that the cans cause pollution that has to be cleaned up by society. It could be that all that sugar or corn syrup inside of people's bloodstream gives them diabetes or decays their teeth, and society is going to have to pay for it somehow.

Another way to think about it is we could add those negative externalities to the marginal private costs, and we could get a marginal social cost curve. Let me do that. So, if we add the negative externalities, we get a marginal social cost curve. This factors in the negative externalities, so I'll call this the marginal social cost.

Let's say for soda, the private benefit, just for simplicity, is equal to the social benefit on the margin. I'll say this is the same thing as the marginal social benefit curve. Now, if you think about it from society's point of view, what is the optimal price and quantity? Well, then you want to think about where marginal social cost is equal to marginal social benefit.

If you produce, you want to keep producing as long as the social benefit is higher than the social cost. But then when the social cost is higher than the social benefit, well then that's not good. Then you're going to create negative benefit or harm to society. So, it would be rational to produce up to this quantity, this quantity right over here.

So, this is the optimal quantity from a societal point of view, and this would be the optimal price from a societal point of view. But if you just let the private markets happen as they are, what happens? Well, then you're overproducing from a societal point of view. If you think about it from a societal point of view, this is what is optimal, but you produce all this quantity where the marginal social cost is higher than the marginal social benefit.

All of this is going to take away from society's benefit from the total surplus for society. This is going to create deadweight loss because these quantities are different. Now, we could also think about a scenario with positive externalities. Let's imagine the exercise equipment market.

We could draw similar curves. So here we have quantity, we have price, we have our marginal private benefit curve, which would be our demand curve—marginal private benefit. We have our marginal private cost curves just like that—marginal private cost. If we just let this market operate, just thinking about the private cost and benefit, we would produce that quantity, and I'll say that that's just considering the private side of things, and we would be at that price.

But let's say that there's a positive externality here. So this is a positive externality. What is it? Well, the more exercise equipment that's out there, the more people they’re going to exercise. It's going to make them happier; it's going to lower the health care costs. So, we would want to add that benefit of that positive externality to the marginal private benefit curve to get the marginal social benefit curve.

So let's do that. We're going to add to this, and we're going to get the marginal social benefit curve—marginal social benefit. Let's say the marginal social cost is the same thing as the marginal private cost curve—marginal social cost right over here.

So, if you think about what's optimal for society, society should want more and more exercise equipment to be produced as long as the marginal social benefit is higher than the marginal social cost. But as soon as the marginal social cost gets higher than the marginal social benefit, then that makes no sense. That would create negative value.

What's optimal for society is to produce up to that. So this is the quantity that's optimal for society. This is the price that's optimal for society. But if we just let the private benefit and cost decide the equilibrium price and quantity, well, we're only going to produce this far. So from a societal point of view, we lost out on all of this quantity where the marginal social benefit is higher than the marginal social cost.

So you have this deadweight loss right over there. The big takeaway here is when you factor in negative externalities or positive externalities, you might discover deadweight loss to society. An interesting question is to think about how could society rectify that? There are ways to start to at least approach it.