Negative externality in production and consumption

Externalities

The cost or benefit a third party receives outside the price mechanism

Negative externality in production

Negative Costs to 3rd parties as a result of the production

Eg.Pollution

Deforestation

Negative Production externality diagram

Firms are ignoring the full social cost due to self interest, they only consider their private costs. This means that MPC is lower than MSC. As a result the market allocates resources at p1q1 which is the private optimum level. The end result is an overproduction from q* to q1 where there is a misallocation of resources. Between q* and q1 the social cost of production exceeds the social benefit meaning resources are being used inefficiently. This creates a deadweight welfare loss represented by the triangle abc

Deadweight loss- abc (Always points at the social equilibrium)

Negative externalities in consumption

Negative costs to 3rd parties as a result of the actions of consumers

Eg. Smoking, Excessive alcohol , Excessive fast food

Negative externality in consumption diagram

Consumers are ignoring the full social benefit of their actions, they are only considering their private benefits due to self interest as they want to maximise their utility. This means that MPB is greater than MSB. Which results in the market allocating resources at p1q1 at the private optimum level. This leads to an overconsumption of these goods which causes a misallocation of resources and inevitably market failure. Between q* and q1 the social cost of consumption exceeds the social benefit creating a deadweight welfare loss at the triangle abc.

DWL- abc