While pollution yields both benefits and costs to society, in a market economy without government intervention too much pollution will be produced. In that case it is polluters alone—owners of power plants or gas-drilling companies, for example—who decide how much pollution is created. And they have no incentive to take into account the cost that pollution inflicts on others.

Figure 16-2 shows the result of this asymmetry between who reaps the benefits and who pays the costs. In a market economy without government intervention, since polluters are the only ones making the decisions, only the benefits of pollution are taken into account when choosing how much pollution to produce. So instead of producing the socially optimal quantity, Q_OPT, the market economy will generate the amount Q_MKT. At Q_MKT, the marginal social benefit of an additional unit of pollution is zero, while the marginal social cost of an additional unit is much higher—$400.

Why? Well, take a moment to consider what the polluter would do if he found himself emitting Q_OPT of pollution. Remember that the MSB curve represents the resources made available by tolerating one more unit of pollution. The polluter would notice that if he increases his emission of pollution by moving down the MSB curve from Q_OPT to Q_H, he would gain $200 − $100 = $100. That gain of $100 comes from using less-expensive but higher-emission production techniques. Remember, he suffers none of the costs of doing this—only others do. However, it won’t stop there. At Q_H, he notices that if he increases his emissions from Q_H to Q_MKT, he would gain another $100 as he moves down the MSB curve yet again. This would be achieved by using even cheaper and higher-emission production techniques. He will stop at Q_MKT because at this emission level the marginal social benefit of a unit of pollution is zero. That is, at Q_MKT he gains nothing by using yet cheaper and dirtier production techniques and emitting more pollution.

The market outcome, Q_MKT, is inefficient. Recall that an outcome is inefficient if someone could be made better off without someone else being made worse off. At an inefficient outcome, a mutually beneficial trade is being missed. At Q_MKT, the benefit accruing to the polluter of the last unit of pollution is very low—virtually zero. But the cost imposed on society of that last unit of pollution is quite high—$400. So by reducing the quantity of pollution at Q_MKT by one unit, the total social cost of pollution falls by $400 but the total social benefit falls by virtually zero.

So total surplus rises by approximately $400 if the quantity of pollution at Q_MKT is reduced by one unit. At Q_MKT, society would be willing to pay the polluter up to $400 not to emit the last unit of pollution, and the polluter would be willing to accept their offer since that last unit gains him virtually nothing. But because there is no means in this market economy for this transaction to take place, an inefficient outcome occurs.