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Marginal Private/Social Cost Curves and Marginal Private/Social Benefit Curves These graphs build on the Supply and Demand Graph. For a review, see Graphic Details from Chapter 2. The graphs in this chapter look at what happens in markets when all of the costs and benefits are not private. That is, when some of the costs or benefits in a market fall on other than the producers or consumers in the market. The graph illustrates what happens to equilibrium price, quantity and welfare when there are SOCIAL costs that fall on others in society. The demand curve slopes downward due to the "Law of Demand." As price increases, quantity demanded decreases and as price decreases, quantity demanded increases. One way to explain why demand curves have this negative slope is through a discussion of marginal benefits. As you consume more and more of a good, the marginal (or additional) benefit received from an additional unit decreases. You receive more benefit from the first unit than you do from successive units. This is also true for the market as a whole. Because marginal benefit falls as more of a good is consumed, the price consumers are willing to pay for each successive unit falls. Consumers will pay a higher price for the first unit (which brings relatively high marginal benefits) than they will for the next units (which have relatively lower marginal benefits). Thus, the demand curve represents the marginal benefits received from consuming a good. The demand curve is the marginal benefit curve for consumers.
The above explanation holds true when all benefits from a good accrue to the private consumer. However, in some cases there are benefits that accrue to others. For example, all of society receives benefits from education. The demand curve represents marginal private benefits, not marginal social benefits, because it includes ONLY benefits that accrue to the consumer. The supply curve represents the quantity producers are willing and able to supply at various prices. The relationship between price and quantity supplied is positive — as price increases, quantity supplied increases and as price decreases, quantity supplied decreases. This can be explained using marginal cost. Since the supply curve shows the price that must be received to sell each successive unit, it reflects the marginal cost of each unit. Firms will not sell a unit for less than their cost of production, so the supply curve shows the firms' marginal cost of production. As more units are produced, the additional cost of producing increases, yielding the positively sloped marginal cost (supply) curve.
The above explanation holds true ONLY when all costs from production fall on the firm. In some cases, costs of production fall on others in society. For example, when a firm dumps waste into a river rather than paying to dispose of it another way the cost of waste disposal falls on society (all those who have lost access to a clean river). In this example, the marginal social cost of production exceeds the marginal private costs of the firm. If the additional costs of waste disposal are considered, the marginal (social) cost curve is farther to the left. This shows that for every quantity the cost is higher when the social costs are added.
This graph shows that equilibrium quantity is higher and price lower when only the marginal PRIVATE costs are considered (Qp and Pp). When the true total costs of production are considered (using the marginal SOCIAL cost curve) the equilibrium quantity is lower and price is higher (Q* and P*). Psc represents the true cost (including both private and social) of producing Qp. When a higher quantity is produced at a lower price than would be the case if ALL costs were considered, society experiences a welfare loss. The loss is shown on the graph as the striped area. This area represents the social well being lost as a result of the firm NOT considering social as well as private costs (Q is higher and P lower than if social costs are considered). When the costs of dumping in the river are not considered by the market, more is produced and therefore the river becomes more polluted than would be the case if the loss of the clean river were considered. |
