- Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party.
Examples of negative externalities
- If you play loud music at night, your neighbour may not be able to sleep.
- If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.
- If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.
- If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.
- With a negative externality the Social Cost > Private Cost
Production negative externality
When producing a good causes a harmful effect to a third party. E.g. Burning coal, creates pollution.
- In a free market people ignore the external costs to others. Therefore output will be at Q1 (where Demand = Supply).
- This is socially inefficient because at Q1 – Social Cost > Social Benefit.
- Social efficiency occurs at Q2 where Social Cost = Social Benefit
The red triangle is the area of dead-weight welfare loss. It indicates the area of overconsumption (where MSC is greater than MPC)
Negative externality of consumption
This occurs when consuming a good causes a harmful effect to a third party.
For example, consuming alcohol leads to an increase in drunkenness and social disorder. The social benefit is less than the private benefit.
In a free market, we get Q1 output. But at this output, the social marginal cost is greater than the social marginal benefit.
Social efficiency occurs at a lower output (Q2) – where social marginal benefit = social marginal cost.
The red triangle is the area of dead-weight welfare loss.
Implications of negative externalities
If goods or services have negative externalities, then we will get market failure. This is because individuals fail to take into account the costs to other people.
To achieve a more socially efficient outcome, the government could try tax the good with negative externalities. This means that consumers pay the full social cost.