2.8.2 Negative Externalities

• Negative externalities of production are 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
  • Common examples include air pollution, water contamination, health problems in local communities
     

External costs of production (negative externality) result in an over-provision shown by the gap between Q_opt and Q_e

 

Diagram Analysis

• 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
• There is an opportunity for government intervention (indirect taxes, legislation, regulation etc.), to force this market to be more socially efficient
• Any intervention that reduces the welfare loss will be beneficial

• Negative externalities of consumption are often created during the consumption of a good/service e.g. the waste generated outside fast food outlets often has to be cleaned up and paid for using taxpayers' funds
  
  
• 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
  • Common examples include cigarettes, alcohol, fatty foods, single-use plastic products etc.
      

External costs of consumption (negative externality) result in an over-consumption shown by the gap between Q_opt and Q_e

 

Diagram Analysis

• The marginal social cost (MSC) is assumed to be equal to the marginal private cost (MPC) as the focus is on the consumer side of the market
• The free-market equilibrium can be seen at P_eQ_e. This is where the MPB = MSC
• The larger the external costs in consumption, the larger the gap between the MPB and the marginal social benefit (MSB)
• 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-consumption of this good/service equal to Q_e-Q_opt
• The factors of production used to manufacture this over-consumption represent a welfare loss to society (pink triangle)
• To be socially efficient, fewer factors of production should be allocated to producing this good/service
• There is an opportunity for government intervention (indirect taxes, legislation, regulation etc.), to force this market to be more socially efficient
• Any intervention that reduces the welfare loss will be beneficial

• Demerit goods are goods which have external costs in consumption
  • These goods are usually addictive and harmful for consumers e.g. gambling, alcohol, drugs, sugary foods/drinks
  • Governments often have to regulate these goods in such a way that they raise the prices and/or limit the quantity demanded 
     

•  The activities of producers can generate significant external costs e.g. pollution caused by coal-burning power stations during the production of electricity
  • However, electricity is considered to be a merit good
  • The smoke is a by-product and not a good/service
     
• For this reason, economists usually consider demerit goods to be goods used in consumption