Negative Externality

Imagine that in the area you live, there is a steel company that contaminates the water you drink. Due to the contaminated water, you incur the cost of buying more expensive drinkable water and have to pay for check-ups at the doctors to ensure that you don't get any disease. This extra cost that you incur as a result of the company's actions is what is known as a negative externality. 

Negative Externality Negative Externality

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Table of contents

    Should the company be paying for the cost you incur due to water contamination? Should the government force the company to reduce the quantity they produce? Most importantly, how can companies be held accountable for the cost their negative externalities impose on others?

    Read on to find out the answers to these questions, discover different types of negative externalities with examples, and learn how governments can correct effects of negative externalities.

    Negative Externality Definition

    A negative externality is a situation where an economic activity imposes costs on people not involved in that activity without their consent or compensation. For example, factory pollution can harm nearby residents' health, who have to bear the cost of medical treatment, decreased property values, and reduced quality of life. Negative externalities are considered one of the market failures.

    Negative externality occurs when the production or consumption of a good or service imposes costs on third parties who are uninvolved in the transaction and do not receive compensation for those costs.

    Pollution is one of the most common negative externalities that individuals face. Pollution worsens when companies decide to increase their earnings while simultaneously decreasing their expenses by introducing new practices that are worse for the environment.

    In the process of this, the company contributes to a significant increase in the amount of pollution. Pollution causes disease, which reduces the ability of one to provide labor and increases medical liabilities.

    In economics, negative externalities arise between consumers, producers, and both.

    They may have a negative impact, which occurs when the activity of one party results in costs being incurred by another party, or they can have a positive impact, which occurs when the action of one party results in advantages being enjoyed by another party. We call it a positive externality.

    Check out our explanation on Positive Externalities

    Negative externalities are responsible for the inefficient allocation of resources in the economy due to the cost they impose on third parties.

    Fortunately, there are ways in which negative externalities could be overcome and solved. One of the main ways through which negative externalities could be solved is through rules and regulations that limit negative externalities.

    Negative Externality Examples

    Here are five examples of negative extenralities:

    1. Air pollution: When factories emit pollutants into the air, it can harm the health of nearby residents, causing respiratory problems and other illnesses.
    2. Noise pollution: Loud noises from construction sites, transportation, or entertainment venues can cause hearing damage and other negative health effects for nearby residents.
    3. Traffic congestion: When too many cars are on the road, it can lead to delays and increased commute times, as well as increased air pollution and greenhouse gas emissions.
    4. Deforestation: When forests are cut down for agricultural or industrial purposes, it can lead to soil erosion, loss of biodiversity, and reduced ability to absorb carbon dioxide from the atmosphere.
    5. Secondhand smoke: Cigarrete consumption in public places, it can harm the health of non-smokers who are exposed to the smoke, increasing the risk of respiratory illnesses and cancer.

    Let's take a look at one example in more detail!

    Let's consider the case of a steel mill dumping its trash in a river. The river is used by fishermen that rely on it for their daily catch.

    In such a case, the steel mill contaminates the river with the steel plant's waste. The plant's steel waste is a highly toxic material to all the fish that live in the river.

    As a result, the amount of waste dumped into the river by the steel company determines the number of fish that may live there.

    Nevertheless, the firm does not have any incentive to think about the consequences their production process might have on the fishermen before making that choice. This hugely impacts the fishermen's lives as it is their primary source of income, which the company is taking away from them.

    In addition, there is no market where the price of steel can appropriately reflect these additional expenditures incurred outside the production process of the company. These additional expenditures are known as negative externalities that a steel mill causes for the fishermen.

    Negative Externalities Graph

    The negative externalities graph shows how inefficient allocation of resources occurs due to negative externalities.

    It is essential to know that negative externalities are not considered in the cost. When firms do not face a cost for the negative externalities they cause upon others, they are incentivized to keep increasing the total output produced. This causes economic inefficiencies and results in excess production and unnecessary social costs.

    Let's consider a steel plant that dumps its waste in the water, which fishermen use to catch fish and use as a source of income. Let's also assume that the steel firm is in a perfectly competitive market.

    Negative Externality Graph: Firm

    Figure 1 down below shows the negative externality graph for a firm.

    Negative Externalities, Negative externalities of a firm, StudySmarterFig 1. Negative externalities of a firm

    Let's start considering a firm that produces steel. Like any other firm in a perfectly competitive market, the price is set at the point where the marginal revenue equals the firm's marginal cost. The firm in a perfectly competitive market is faced with a perfectly elastic demand curve; therefore, the price equals demand and marginal revenue.

    How about the cost of the negative externality the firm causes? To account for the negative externality the firm causes, we should account for two critical curves: The marginal external cost (MEC) and the marginal social cost (MSC).

    The marginal external cost (MEC) is the cost that negative externalities impose on others due to the firm's increase of output by one unit.

    Notice that the MEC is upward-sloping. The reason is that the increase in production also increases the cost that negative externalities impose due to the firm's production.

    The Marginal Social Cost (MSC) is the sum of the marginal cost of production and the marginal external cost.

    The MSC curve takes into account the marginal cost of the firm as well as the cost that occurs due to the negative externality. The MSC considers the efficient level of production from a social perspective (taking into account the negative externality)

    \(MSC = MC + MEC \)

    When the negative externality is not considered, the firm produces at Q1. However, due to the cost that occurs from a negative externality, the firm should produce at Q2, which would be the efficient production level.

    At Q2, both the steel firm and the fisherman would be happy. That means that the allocation of resources would be much more efficient.

    Negative Externalities Graph: Industry

    Now let's consider the industry for steel, where all steel firms dump their waste in the water. The steel industry consists of a downward-sloping demand curve and an upward-sloping supply curve.

    Negative Externalities, Negative externalities firm and industry, StudySmarterFig 2. - Negative externalities firm and industry

    In figure 2, on the left-hand side of the graph, you have one steel firm producing. On the right-hand side of the graph, you have many steel firms producing.

    The equilibrium price and quantity are at point 1, where no negative externality cost is considered. At this point, the firm produces Q1 units of steel, and the price of steel is P1.

    However, adding up all the marginal external cost curves and marginal social cost curves, we get MEC' and MSC.'

    The MSC' is the sum of all the marginal costs faced by firms and the sum of the marginal external cost resulting from negative externalities.

    When the cost of a negative externality is considered, the price of steel should be P2, and the industry output should be Q2 units of steel. At this point, the cost caused by negative externalities is also faced by the firm, not only the fishermen.

    The point where the MSC intersects the demand curve is the point where the resources are allocated more efficiently in the economy. When only the demand and MC curves intersect, the economic resources are not distributed as efficiently.

    Types of Negative Externalities

    There are two types of negatve externalites

    • negative externality of production, and
    • negative externality of consumption.

    Negative Externality of Consumption

    Negative externalities of consumption occur when one person's consumption negatively impacts the well-being of others for whom that person does not provide compensation.

    The natural resources we as human beings have are scarce, and one day individuals will run out of them.

    If a piece of land, for example, is overconsumed, it loses its fertility and can't produce as many vegetables as it used to.

    Other resources are scarce as well. That means that as a result of consumption, some other individuals will face the negative effect of no longer having access to food and other necessities.

    Additionally, the consumption of demerit goods leads to negative externalities.

    Demerit goods are goods whose consumption leads to negative externalities.

    Common examples include smoking cigarettes, which may lead to others engaging in passive smoking; consuming excessive amounts of alcohol, which can ruin a night out for others; and creating unnecessary noise pollution.

    Negative Externality of Production

    Negative externality of production refers to the situation where a producer's activity imposes costs on society that are not reflected in the price of the product. This means that the producer does not bear the full cost of producing the good, and instead, the cost is shifted onto others.

    Negative externality of production is a situation where the production of a good or service by one economic agent imposes costs on others who are not involved in the transaction and who do not receive compensation for those costs.

    Imagine a factory that produces clothing. The factory emits pollutants into the air and water, causing harm to nearby residents and wildlife. The cost of this pollution is not reflected in the price of the clothing, so the factory does not bear the full cost of production. Instead, the cost is borne by society in the form of increased healthcare costs, reduced quality of life, and environmental damage.

    Correcting a Negative Externality

    Correcting a negative externality becomes essential when the production of a good results in the incurrence of spillover costs. One of the central authorities capable of mitigating the effect of a negative externality is the government. One way the government can reduce negative externalities is through taxes.

    The amount of tax a company has to pay on a good directly impacts the production cost that a company incurs. The production costs then impact how many units the business will produce. When the cost of production is low, companies will produce more output, and when the cost of production is high, companies will produce less output.

    By increasing taxes, the government makes the production of a good or service more expensive. This will cause companies to reduce their total output produced. As a result of this, the negative externalities that result from the production of that good decrease.

    The amount of tax that the government decides to impose should take into account and be proportional to the cost of any spillovers—this way, the company pays the true cost of manufacturing that particular good.

    Governments may also mitigate negative externalities via the implementation of relevant legislation. The general public often looks to governments to adopt legislation and regulations and pass laws to mitigate the unfavorable consequences of externalities. Regulations pertaining to the environment and laws concerning health are two examples among many more.

    Negative Externalities - Key takeaways

    • Externalities are the result of an industrial or commercial activity that affects other parties but is not represented in the pricing on the market for that activity.
    • Negative externalities occur when the production or consumption of goods results in a cost being incurred by a party other than the producer or consumer of the good.
    • Negative externalities are responsible for the inefficient allocation of resources in the economy due to the cost they impose on third parties.
    • The marginal external cost (MEC) is the cost that negative externalities impose on others due to the firm's increase of output by one unit.
    • The Marginal Social Cost (MSC) is the sum of the marginal cost of production and the marginal external cost.
    Frequently Asked Questions about Negative Externality

    What is a negative externality in economics?

    Negative externalities in economics occur when the production or consumption of a good results in a cost being incurred by a party other than the producer or consumer of the good.

    What is the most common negative externality?

    Pollution is the most common negative externality.

    What is an example of a positive and negative externality?

    Pollution is an example of a negative externality. 

    Decorating the outside of your house for Christmas is an example of a positive externality.

    What is the problem with negative externalities?

    Negative externalities are responsible for the inefficient allocation of resources in the economy due to the cost they impose on third parties.

    How can negative externalities be prevented?

    Government legislation can help prevent externalities.

    Why do externalities cause inefficiency?

    Negative externalities cause inefficiency because they create a situation where the costs of an activity are not fully borne by the parties involved in that activity. The pollution created during production is a cost that is not reflected in the price which leads to inefficiency.

    How can a negative externality such as water pollution lead to disequilibrium?

    A negative externality such as water pollution can lead to disequilibrium because it creates a situation where the social costs of an activity exceed the private costs.

    If the company were to internalize the cost of the pollution by paying for the cleanup or reducing their pollution output, the cost of production would increase, and the supply curve would shift leftward, reducing the quantity produced and increasing the price. The new equilibrium would reflect more efficient allocation of resources.

    Test your knowledge with multiple choice flashcards

    _________ occur when the production or consumption of a good results in a cost being incurred by a party other than the producer or consumer of the good.

    In economics, negative externalities arise between _____________.

    _______ is one of the most common negative externalities that individuals face. 

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