Notes on Externalities, Graphically

January 20, 2023

1 Notes on Externalities, Graphically

These supplemental notes are to help more graphically inclined learners visualize deadweight losses
and changes in surpluses in perfectly competitive markets with externalities. For visual clarity,
these examples will only have cases with constant marginal external surpluses. You will not be
tested on identifying these areas graphically.
For one negative and one positive example, these notes slowly break down the components of
surplus under perfect competition versus the social planner’s optimum before combining all the
components to illustrate the difference in total surpluses. They do not cover markets after Pigouvian
interventions, but that would be a simple extension of the pictures herein.

1.1 Negative Externality

Consider Matt’s Smokehouse, which we discussed briefly in class. The Smokehouse generates con-
stant negative externalities for every slab of meat produced. The numerical details of the economy
can be summarized by the following:
1. Demand side: 𝑃 (𝑞) = 100 − 𝑞
2. Production side: 𝑐 = 20 (remember little 𝑐 is marginal cost)
3. Externalities: 𝑀 𝐸𝑆(𝑞) = −10
Every graph below depicts the four types of benefit and cost curves: 𝑃 𝑀 𝐵, 𝑃 𝑀 𝐶, 𝑆𝑀 𝐵, and
𝑆𝑀 𝐶. In this case 𝑃 𝑀 𝐵 = 𝑆𝑀 𝐵 as there is no positive externality, meanwhile the difference in
𝑆𝑀 𝐶 and 𝑃 𝑀 𝐶 is the 𝑀 𝐸𝑆 (also called 𝜏 in class).

1.1.1 Competitive Equilibrium

The first graph just shows the competitive equilibrium outcomes, 𝑞 ∗ which ensures that 𝑃 (𝑞) = 𝑐.

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The following two sets of three graphs depict the components of surplus, in both ways we discussed
them. The first set considers net surpluses (e.g. consumer surplus is total utility minus prices paid).
The second sets considers the surplus like the planner would, that is ignoring financial transfers like
payments and revenues. You will see that either approach yields the same picture of total surplus.
To be explicit for each set you will see three figures:
1. In the first set – CS, PS, ES
2. In the second set – total utility, total production costs, external surplus
To rebel a bit against accountants, red areas are positive for surplus and black areas are negative.
Notice that the middle graph in the first set for PS is not a mistake. The profits are the firm are 0
in this case as price is exactly equal to marginal cost for all pieces of meat sold.

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Combining all three components in one set gives the total surplus. Either set should yield the
same result. Black and red areas that overlap cancel each other out and we are left with the
following picture.

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1.1.2 Optimality
The first graph adds the optimal quantity, 𝑞,̃ which satisfies the condition 𝑆𝑀 𝐵(𝑞) = 𝑆𝑀 𝐶(𝑞).
Note that, as expected, 𝑞 ̃ < 𝑞 ∗ because the externality in this market is negative.

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The following three graphs now depict the components of surplus under 𝑞.̃ Note that only the
“non-price’ ’ set (set 2 above) makes sense to look at here. The planner does not have to set prices
to achieve this optimum.
Notice that compared to when 𝑞 = 𝑞 ∗ , under the optimal:
1. Total utility ↓ (bad for TS)
2. Total prod. costs ↓ (good for TS)
3. ES ↓ (good for TS)

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The next set of figure simply graphically compares the change in these three components.

Total surplus under the optimum is again the sum of the components. Notice that the difference
from the total surplus in the competitive equilibrium is precisely the amount recovered by lowering
external surpluses (little black triangle in the first total surplus picture). This little black area was
the deadweight loss accrued by the competitive market ignoring the effect of its activities on
social surplus (specifically the externalities).

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1.2 Positive Externality
Consider Matt’s Mac Gallery. Visitors to the gallery generate constant positive externalities
(changed to constant from the example in class) because of the happiness and serenity they carry
with them for the rest of the day after the visit. The numerical details of the economy can be
summarized by the following:
1. Demand side: 𝑃 (𝑞) = 100 − 2𝑞
2. Production side: 𝑐 = 20
3. Externalities: 𝑀 𝐸𝑆(𝑞) = 20
Every graph below depicts the four types of benefit and cost curves: 𝑃 𝑀 𝐵, 𝑃 𝑀 𝐶, 𝑆𝑀 𝐵, and
𝑆𝑀 𝐶. In this case 𝑃 𝑀 𝐶 = 𝑆𝑀 𝐶 as there is no negative externality, meanwhile the difference in
𝑆𝑀 𝐵 and 𝑃 𝑀 𝐵 is the 𝑀 𝐸𝑆 (also called 𝜏 in class).

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1.2.1 Competitive Equilibrium
The first graph just shows the competitive equilibrium outcomes, 𝑞 ∗ which ensures that 𝑃 (𝑞) = 𝑐.

The following two sets of three graphs depict the components of surplus, in both ways we discussed
them. The first set considers net surpluses (e.g. consumer surplus is total utility minus prices paid).
The second sets considers the surplus like the planner would, that is ignoring financial transfers like
payments and revenues. You will see that either approach yields the same picture of total surplus.
To be explicit for each set you will see three figures:
1. In the first set – CS, PS, ES
2. In the second set – total utility, total production costs, external surplus
As before, red areas are positive for surplus and black areas are negative.

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Notice that the middle graph in the first set for PS is not a mistake. The profits are the firm are 0
in this case as price is exactly equal to marginal cost for all visitors in the gallery.

Combining all three components in one set gives the total surplus. Either set should yield the
same result. Black and red areas that overlap cancel each other out and we are left with the
following picture.

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1.2.2 Optimality
The first graph adds the optimal quantity, 𝑞,̃ which satisfies the condition 𝑆𝑀 𝐵(𝑞) = 𝑆𝑀 𝐶(𝑞).
Note that, as expected, 𝑞 ̃ > 𝑞 ∗ because the externality in this market is positive.

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The following three graphs now depict the components of surplus under 𝑞.̃ Note that only the
“non-price’ ’ set (set 2 above) makes sense to look at here. The planner does not have to set prices
to achieve this optimum.
Notice that compared to when 𝑞 = 𝑞 ∗ , under the optimal:
1. Total utility ↑ (good for TS)
2. Total prod. costs ↑ (bad for TS)
3. ES ↑ (good for TS)

[]

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The next set of figure simply graphically compares the change in these three components.

[]

Total surplus under the optimum is again the sum of the components. Notice that the difference
from the total surplus in the competitive equilibrium is the extra amount gained from increasing
the external surplus over the additional costs (specially colored green area below). This green area
was the deadweight loss accrued by the competitive market ignoring the effect of its activities on
social surplus (specifically the externalities).

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