MSB and MSC

Externality theory

How do we incorporate wider society into our model?

If we assume that consumers make decisions only based on their own private benefit…

…and producers make decisions only based on their own private costs…

….then sometimes the free market position may not be allocatively efficient, as the consumption or production of a product impacts third parties.

Benefits of consumption:

Marginal private benefit (MPB) is the benefit recieved by consumers when an additional unit of a product is consumed.

Marginal social benefit (MSB) is the benefit recieved by society when an additional unit of a product is consumed.

MSB = MPB + external benefits to 3rd parties ( or - external costs of 3rd parties)

When education is consumed:

  • Consumers gain MPB (skills, higher income earning potential)

  • Their employers/ the economy gains external benefits ( a more productive workforce).

  • MSB>MPB

When cigarettes are consumed:

  • Consumers gain MPB (enjoyment of smoking)

  • The healthcare service incur external costs (of treating smoking related illness)

  • MSB<MPB

Costs of production:

Marginal private cost (MPC) is cost paid by producers when an additional unit of a product is produced.

Marginal social cost (MSC) is the cost paid by society when an additional unit of a product is produced.

MSC = MPC + external costs to 3rd parties ( or - external benefits to 3rd parties)

When electricity is produced:

  • Producers pay MPC (cost of land, labour and capital)

  • The healthcare system pays external costs (pollution emitted damages health)

  • MSC>MPC

When computers are produced in Zambia by a multi-national corporation:

  • Producers pay MPC (for land, labour and capital)

  • The economy incurs external benefits (if, in the production process, workers are given basic skill pre vision in how to use these computers, making them more productive)

  • MSC<MPC

How does this impact allocative efficiency?

Allocative efficiency occurs when social surplus is maximised.

  • If a product will benefit society more than it will cost society than we should produce it.

  • If a product will cost society more than it will benefit society, than we shouldn’t produce it.

  • We should be looking at the two social curve when analysing allocative efficiency.

  • At first, MSB is above MSC. We should produce. When MSC rises above MSB, we shouldn’t produce.

  • Allocative efficiency occurs where MSB=MSC and quantity Q* is brought and sold at price P*.

  • But in free markets, consumers and producers only look at their own private benefits and costs.

  • The free market equilibrium is where MPB=MPC (D=S) and quantity Q is brought and sold at price P.

  • If there are any external costs or external benefits, the two equilibriums will not be in the same place. The free market is allocatively inefficient.

  • Market failure occurs when social surplus is not maximised in a free market. The government must intervene to get the market to Q (allocative efficiency ).