Final answer:
At competitive market equilibrium, for the last unit produced, if there is an externality, the market price may not reflect the true social cost or benefit. The size of an external benefit or cost is given by the difference between the socially optimal price and the market price. Deadweight loss occurs when the market does not account for these externalities.
Step-by-step explanation:
At the competitive market equilibrium, the market price (P) is equal to the marginal cost (MC) of producing the last unit. This equilibrium condition reflects the point where the social benefits of production, reflected in the consumers' willingness to pay, are equal to the social costs of production.
If the size of an external benefit were to be measured, it would be represented by the difference between the social optimum price (Po) and the competitive market price (Pm). Conversely, the size of an external cost would be the difference between the market price (Pm) and the socially optimal price (Po).
Due to the presence of either positive or negative externalities, the actual market price (Pm) deviates from the social optimum price (Po), leading to either underproduction or overproduction relative to the socially optimal level. In the case of negative externalities, like second-hand smoking, the social cost includes both the private cost of production and the external cost.
The socially optimal output and price (Pe and Qe) would be lower than the market equilibrium (Pm and Qm), accounting for these costs. The deadweight loss is represented by the area between the social and private cost curves at the market output.