Negative Externalities: Which Area Is the Deadweight Loss?

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Here's a classic economics question. A graph shows demand, private marginal cost, and social marginal cost for something that causes a negative externality. Which of these three statements are true? Let's build the graph one line at a time. First, demand. This line shows how much buyers value each extra unit. The first few units are worth a lot to them. Later ones are worth less, so the line slopes down. Next, private marginal cost. That's what it costs the producer to make one more unit. Picture a factory making steel. It pays for workers, power and materials, and each extra unit costs a bit more than the last. But the factory also sends smoke into the air, and the people nearby pay for that with their health. That cost never shows up on the factory's bills. Add it on, and you get social marginal cost: the full cost to everyone. The gap between the two lines is the harm each unit does to bystanders. So what does the market do? Buyers and sellers only weigh their own costs. They keep trading until demand meets private marginal cost. That's Q two. What's best for society as a whole? Count every cost, smoke included, and stop where demand meets social marginal cost. That's Q one. So statement A is true. Q one is the socially optimal level of output. That means the market makes too much: every unit between Q one and Q two. Take one of those units. Its value to buyers is the height of the demand line. Its full cost to society is the height of the social cost line, and that's higher. This unit costs more than it's worth. Add up that shortfall for every extra unit, and you fill in this triangle, between social marginal cost and demand. That's area C: the deadweight loss. It's value that's simply destroyed, because nobody paid for the smoke. So statement C is true. What about area B? It sits under demand and above private cost. It's the gain buyers and sellers get from those extra units, so it isn't lost. The problem is that the smoke from those same units costs B plus C. The trade earns B, the smoke costs B plus C, and society ends up C worse off. So statement B is false. And area A is the smoke damage from the first Q one units. It's a real cost, but those units are worth making anyway, so it isn't a loss. So the answer: A and C are both true, and B is false. If your list includes both A and C, pick that one. And the fix? A tax equal to the gap lifts private cost up onto social cost, and the market lands at Q one on its own.