Socially efficient and inefficient market outcomes
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Socially efficient and inefficient market outcomes
- [Sal] Let's study the market for soda a little bit. And so, we're going to draw our traditional axes, so that is price, and that is quantity. And we have seen our classic supply and demand curves. So, this could be our upward-sloping supply curve at a low price. Not a lotta people wanna produce soda, but as price goes higher, more and more people would wanna produce it. And 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. And then, on the demand side, we have our classic downward-sloping curve at a high price. Not a lotta people are gonna want the soda. But then, as price gets lower, a lot more people are gonna want the soda. So, this is our demand curve, which we could also view as a marginal benefit curve. That first unit of soda, someone's going to get a huge benefit for it, and so they have a high willingness to pay. And 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 this downward sloping. And so, we have our, this, we could also view as a marginal benefit curve. And we have, and this is 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. And so, let me relabel this a little bit. Instead of just saying marginal benefit, I'm gonna call this the marginal private benefit. And instead of marginal cost, I'm going to call this the marginal private cost. And this is the equilibrium price we would get to if we just factored in the private the costs and benefits. And this is the equilibrium quantity if we just factored in the private costs and benefits. And 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. And 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 'em diabetes or decays their teeth. And society's going to have to pay for it somehow. And so, another way to think about it is we could add those negative externalities to the marginal private cost, and we could get a marginal social cost curve. And so, let me do that. So, if we add the negative externalities, we get a marginal social cost curve. So, this factors in the negative externalities. So, I'll call this the marginal social cost. And let's say, for a soda, the private benefit, just for simplicity, is equal to the social benefit on the margin. So, I'll say this is the same thing as the marginal social benefit curve. But now, if you think about it form society's point of view, what is the optimal price and quantity? Well, then you wanna think about where marginal social cost is equal to marginal social benefit, because if you produce, you wanna 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'd 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. And 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. And so, all of this is going to take away from society's benefit, from the total surplus for society. And so, 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, let's say the, I don't know, exercise equipment market, 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, so marginal private benefit, and we have our marginal private cost curves, just like that, marginal private cost. And 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'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, there's a positive externality. What is it? Well, the more exercise equipment that's out there, the more people that are gonna exercise, it's going to make them happier, it's going to lower their healthcare costs, and so we would wanna add that benefit, that positive externality, to the marginal private benefit curve to get the marginal social benefit curve. So, let's do that. So, we're gonna add to this, and we're going to get the marginal social benefit curve, marginal social benefit. And 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. And so, 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 be what decides the equilibrium price and quantity, well, we're only going to produce this far. So, from a society 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. So, the big takeaway here is, when you factor in negative externalities or positive externalities, you might discover deadweight loss to society. And so, an interesting question is to think about how could society rectify that. And there are ways to start to at least approach it.