To The shaded area on the diagram

To show how this leads to market failure, one has to make a
distinction between the private costs and benefits to the individual consumer
and producer and the social costs and benefits to society as a whole. If we add
together private cost and external cost, the result is social cost. In the
diagram above, P1, Q1 is a free market optimum. This means that the marginal
private cost of consumption and production is equal to the marginal private
benefits. However, if there are negative externalities then the marginal social
cost curve lies above the marginal private cost curve due to the addition of
external costs. If the marginal social cost is positioned away from the
marginal private cost then the marginal external cost of extra output is
assumed to be increasing. The difference between the two curves (MSC and MPC)
shown by the dotted red vertical line is the external cost which is associated
with the output Q1. If these externalities are not taken into account, this can
lead to market failure.

Preferably, one would need another output as shown in the
diagram as Q2 – a quantity which is less than Q1. Without intervention, free
market can overprovide or overconsume goods and services where there are
negative externalities. P2, Q2 in the diagram takes into account the negative
externalities and therefore creates the social optimum output. The equilibrium
level of output delivered by a free market is at Q1 where marginal private
benefit equals marginal private cost and it is allocatively inefficient. One would
assume in this example that there are no externalities arising from consumption
so the social optimum is at P2, Q2 when we take into account the externalities.
There is also a deadweight loss of welfare due to market failure. The shaded
area on the diagram shows the social welfare loss which is caused when the
market output supplied is higher than the social optimum which in tern is a
wasteful allocation of resources. 

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