The Cost-Benefit Framework and the Social Optimum
Idea
Cost–benefit analysis — the marginal principle — is the common engine behind every form of market failure in the syllabus. It compares, unit by unit, what a good costs against what it benefits, and locates the quantity at which society’s welfare is maximised.
Mechanism
The market demand curve is read as a marginal-benefit curve and the market supply curve as a marginal-cost curve, using the four marginal cost and benefit concepts.
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Social optimum. Society’s welfare is maximised at the quantity where . Below it, an extra unit benefits society more than it costs; beyond it, the extra unit costs more than it benefits.
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Free-market equilibrium. Self-interested consumers and producers transact where .
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No market failure. When private and social valuations coincide — and — the free-market equilibrium is the social optimum, since . The market is allocatively efficient.
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Market failure. When private and social valuations diverge — the case with externalities — the free-market quantity at departs from the social optimum at , leaving a deadweight welfare loss.
Considerations
The framework is what makes the deadweight welfare loss measurable on a diagram: it is the accumulated gap between social benefit and social cost over the units that are wrongly produced or not produced. Every externality diagram in this sub-theme is an instance of this single comparison, with one private curve displaced from its social counterpart by the marginal external cost or benefit.