Negative Externalities

What are negative externalities of production?

• Often created during the production of a good/service

• The market is failing due to over-provision of these goods/services as only the private costs are considered by the producers and not the external costs

• If the external costs were considered, the supply would decrease and they would be sold at a higher price

What diagram shows negative externalities of production?

• The marginal social benefit (MSB) is assumed to be equal to the marginal private benefit (MPB) as the focus is on the producer side of the market

• The free-market equilibrium can be seen at P_eQ_e. This is where the MPC = MSB

• The larger the external costs in production, the larger the gap between the MPC and the marginal social cost (MSC)

• The optimum allocation of resources from society’s point of view, would generate an equilibrium where MSB = MSC

  • This can be found at P_optQ_opt

  • There is no market failure at this equilibrium

• The free market is failing due to over-provision of this good/service equal to Q_e-Q_opt

• The factors of production used to manufacture this over-provision represent a welfare loss to society (pink triangle)

• To be socially efficient, fewer factors of production should be allocated to producing this good/service

What are negative externalities of consumption?

• Often created during the consumption of a good/service

• The market is failing due to over-consumption of these goods/services as only the private costs are considered by the consumers and not the external costs

• If the external costs were considered, demand would decrease and they would be sold at a lower price

What diagram shows negative externalities of consumption?