Negative Externalities

Idea

A negative externality arises when the production or consumption of a good imposes an external cost on third parties. Because the cost is unpriced, the marginal social cost lies above the marginal private cost, and the free market over-allocates resources to the good — producing or consuming beyond the social optimum and generating a deadweight welfare loss.

Mechanism

The free market settles at $Q_m$, where $MPB = MPC$, because rational agents weigh only their own private costs and benefits. The social optimum is $Q_s$, where $MSB = MSC$. Since $MSC$ exceeds $MPC$ by the marginal external cost, $Q_m$ lies to the right of $Q_s$: the good is over-produced (production externality) or over-consumed (consumption externality) by $Q_m - Q_s$.

Over that excess, each unit costs society more than it benefits society. Summed across $Q_m - Q_s$, this is the deadweight welfare loss — the triangle bounded by the social-optimum point, the free-market point, and the divergence between the social and private curves at $Q_m$.

• Negative production externality — the external cost attaches to production (a steel mill’s toxic emissions harming nearby residents, uncompensated). The $MSC$ curve sits above $MPC$.

• Negative consumption externality — the external cost attaches to consumption (second-hand smoke from cigarettes harming passive smokers). The diagram is structurally identical: $MSC$ above $MPC$, over-consumption $Q_m - Q_s$.

Diagram

Considerations

Because the externality is unpriced, the market under-prices the good relative to its true social cost, which is why too much is traded. The same diagram serves both the production and the consumption case — only the label on the divergent curve and the wording (over-production vs over-consumption) change. The corrective policies, and the limits on each, are set out in correcting negative externalities; the specific numbers in any worked case (the size of $Q_m - Q_s$, the value of the loss) belong in prose, not on the schematic.