When markets ignore third parties, pollution, vaccines, and the tax/subsidy that fixes the price.
Warming up the engine…
Costs or benefits that spill over onto people outside the transaction, so private incentives and social value diverge and the market quantity is wrong.
MSC = MPC + external cost ; efficient output where MSC = MSB
A factory ignoring its pollution faces costs lower than society's, so it produces too much; a student ignoring the benefits their education gives others buys too little. The fix is to make the spillover private: tax the harm by exactly the external cost (Pigouvian tax), subsidize the benefit, or define property rights and let parties bargain (Coase).
Draw TWO marginal cost (or benefit) curves, private and social, and mark both the market and efficient quantities. The optimal tax equals the vertical gap between them at the efficient output.
Now prove you have it
Move the curve to where you think it lands, and get told exactly which part you got right.
Real-world scenarios on this model
Equilibrium at Q 50, P 40.
Equilibrium: Q* = 50.0, P* = 40.0
Current equations
The market only counts costs that producers pay. If each unit also dumps pollution on neighbors, the true social cost curve (MSC) sits above supply, and the market happily produces past the point where full costs exceed benefits.
Source: Mankiw, Principles of Economics, ch. 10