To the right is a graph for a perfectly competitive firm which generates a negative externality (say pollution) as a by-product of its production. The PMC curve is Private Marginal Cost, the production costs actually paid by the firm. SMC is the Social Marginal Cost or the full social cost of production. SMC > PMC because the negative externality imposes social costs not borne by the firm.

    The firm maximizes profit by producing where PMC = P, to produce QPC. The socially or allocatively efficient amount would be produced where SMC = P or QAE, so the firm overproduces relative to allocative efficiency since it doesn't face the full social costs of production.

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