External Cost and Pollution Shown on the Supply and Demand Model

The supply and demand model is one of the first concepts we learn in economy. It shows the interaction of buyers and sellers in a market, and defines the correct price and quantity for a certain good. Following the price line and the quantity on the graphic, we see that the price and quantity converge to an agreement. The point of intersection between the two curves is the adjusted price and quantity for a good.

The supply and demand forces adjust the quantity of goods in the free market. More people buy if it is cheap then if it is expensive. Above the point of intersection, we have surplus of supply (shortage of demand) and under it, we have surplus of demand (shortage of supply). The price will go down if there is a surplus of supply and it will go up if there is a surplus of demand. The curves could move left or right depending on behavior of the consumers or the producers.

The chart is an instrument we can use to understand the role of pollution in our economy. As shown earlier, pollution has a cost. If a company pollutes a river to produce goods, the population living in the area will consequentially lose the revenue made with the clean water (water bottles, tourism, fishing, water activities, etc.)

Let’s pretend that, for this company, it costs 5 dollars to produce a good. To make a profit of 2 dollars, this product should be sold for 7 dollars. If we include the social costs, producing the product costs 5 dollars and cleaning up the polluted river for each one of them costs 2 dollars. If the company takes responsibility of the external costs (pollution costs), the price of the good should be 9 dollars in order to make the same profit.

This can be shown graphically. The supply curve moves left when we add the social cost. Consequently, the price goes up and the quantity of the demand decreases. In adding pollution to the costs of the producer, we harmonize the production with the environment. If pollution is not taken into consideration when producing a good, we are in a situation of surplus supply.

We can take a larger scale by observing global warming. One element responsible of this phenomenon is human activities related to the combustion of fossil fuel used in transportation (cars, trucks, planes, etc.) To adjust the quantity, gas should be higher in price because we need to pay the social cost of using transport. The price would need to be adjusted by a general tax on the use of gas.

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