When a good or service is produced, there are always some external costs associated with its production. These external costs can be environmental, social, or economic.
For example, the production of smartphones has environmental costs in the form of environmental damage caused by mining for certain minerals used in the smartphone and by the manufacturing process itself.
There is also a social cost associated with the production of smartphones in the form of low wages paid to workers on the assembly line. Finally, there are economic costs in that the production of smartphones increases demand for other goods and services, but may cause short-term inflation.
When a good or service has external costs associated with its production, then the firm’s private supply curve will intersect the market supply curve at more than one point. This article will explain this concept in more detail.
A production generates external costs
When a production process generates external costs, that is, costs to individuals or societies outside of the production process, the supply curve shifts to the left.
A firm’s supply curve represents the amount of output it will produce at a given price. If the price of its product goes up, it will supply more output as it will be more profitable.
When external costs are taken into account, the supply curve shifts left, meaning that at any given price, a firm will produce less output.
When there are no external costs, firms will produce where marginal cost equals market price. At that point, they are earning an average profit, so they will continue to produce at that level.
When there are internal costs (costs borne by the firm itself) and no external costs, firms will still produce at the point where MC=MP1, meaning they earn an average profit.
Examples of production generating external costs
A chemical plant may pay less for the chemicals it needs to produce a good, but it may also produce more harmful byproducts in the process.
A car manufacturer may pay less for the components needed to make a car, but may also put more environmental damage into the process.
A technology company may pay less for the resources needed to make their products, but they may also increase the amount of tech waste produced in the process.
When a good or service requires other inputs to produce its desired output, then there is a cost that goes into that. If a good or service produces external costs, then firms will have an internal cost of production as well as those external costs.
Internal costs of production include things like labor, machinery, and other inputs into production.
The market will not reach an equilibrium
When a good produces external costs, the market will not determine a price that clears the market. A price will be determined, but it will not be a fair price.
Because the price will be too high or too low due to the external costs, there will be a surplus or shortage of the good. A surplus means there is enough of the good to satisfy demand, but there is excess inventory. A shortage means that there is not enough of the good to satisfy demand.
When there is a surplus of a product, the firm can lower its price without losing all of its customers. This is because some customers would be willing to pay more than what the firm would have to lower its price to at that point.
When there is a shortage of a product, the firm has to raise its price or run out of stock. This may keep some customers from purchasing the product at that higher price, which reduces demand.
What can be done about it?
Fortunately, there are solutions to this problem. One solution is for the government to impose a tax on the negative externality.
For example, if pollution was a cost borne by the public, then the government could impose a tax on every unit of pollution. This tax would make the price of the good higher, which would incentivize firms to find ways to lower their pollution output.
Another solution is for the government to subsidize solutions that reduce external costs. This would incentivize firms that produce solutions that reduce external costs to lower their prices, since the government would pay them for reducing environmental costs.
A third solution is for the government to simply regulate emissions directly. For example, they could set emissions targets and require firms to meet these targets by certain dates or face penalties.