Ten Principles of Economics - Part 21. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. | CHAPTER 10 EXTERNALITIES 209 All I can say is that if being a leading manufacturer means being a leading polluter so be it. production the value of the aluminum to consumers as measured by the height of the demand curve exceeds the social cost of producing it as measured by the height of the social-cost curve . The planner does not produce more than this level because the social cost of producing additional aluminum exceeds the value to consumers. Note that the equilibrium quantity of aluminum Qmarket is larger than the socially optimal quantity Qoptimum. The reason for this inefficiency is that the market equilibrium reflects only the private costs of production. In the market equilibrium the marginal consumer values aluminum at less than the social cost of producing it. That is at QMARKET the demand curve lies below the social-cost curve. Thus reducing aluminum production and consumption below the market equilibrium level raises total economic well-being. How can the social planner achieve the optimal outcome One way would be to tax aluminum producers for each ton of aluminum sold. The tax would shift the supply curve for aluminum upward by the size of the tax. If the tax accurately reflected the social cost of smoke released into the atmosphere the new supply curve would coincide with the social-cost curve. In the new market equilibrium aluminum producers would produce the socially optimal quantity of aluminum. The use of such a tax is called internalizing the externality because it gives buyers and sellers in the market an incentive to take account of the external effects of their actions. Aluminum producers would in essence take the costs of pollution into account when deciding how much aluminum to supply because the tax now makes them pay for these external costs. Later in this chapter we consider other ways in which policymakers can deal with externalities. internalizing an externality altering incentives so that people take account of the external effects .
