Negative Externalities

Negative externalities are costs caused by an activity that affect an otherwise uninvolved party who did not choose to incur that cost.

Learning Objective

Describe the impact of a negative externality on society

Key Points

The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production.
Government intervention is necessary to help "price" negative externalities. They do this through regulations or by instituting market-based policies such as taxes, subsidies, or permit systems.
Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative externalities. As a result, firms may produce more units than is optimal from a societal standpoint.
Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative externalities. As a result, firms may produce more units than is optimal from a societal standpoint.

Term

externality
An impact, positive or negative, on any party not involved in a given economic transaction or act.

Example

Smoking creates negative externalities because the secondhand smoke affects third parties that were otherwise not involved in the transaction.

Full Text

A negative externality is a cost that results from an activity or transaction and that affects an otherwise uninvolved party who did not choose to incur that cost.

Reasons for Negative Externalities

The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production. Production decisions are generally based on financial data and most social costs are not measured that way. For example, when a firm decides to open up a new factory, it will not account for the cost that residents accrue by drinking water from a river the factory polluted. As a result, a product that shouldn't be produced, because the total expenses exceed the return, are made because social costs were not considered.

In other words, the costs of production represent individual, or private, marginal costs. The private marginal costs are lower than societal marginal costs, which also capture the true costs of the negative externalities. As a result, producers will overestimate the ideal quantity of the good to produce .

Negative Externality

Graphically, negative externalities occur when social costs are lower than private costs, and firms produce more units than is socially optimal. The ideal equilibrium quantity that reflects negative externalities is Qs, but firms may produce at Qp.

Government Solutions for Negative Externalities

In these cases, government intervention is necessary to help "price" negative externalities. Governments can either use regulation (e.g. outlaw an action) or use market solutions. By instituting policies such as pollution penalties, permitting civil lawsuits by private parties to recover damages for negligent actions, and levying environmental taxes, governments can achieve two things. First, these regulations recover funds to help fix the damage caused by negative externalities. Second, these acts help put a financial price on social costs. With that information, businesses can arrive at a more accurate figure for the costs of production. Businesses can then avoid producing products whose financial and social costs exceed the financial return.

Cigarette smoke

Secondhand smoke is an example of a negative externality; a person chooses to smoke, but others who do not choose to smoke are harmed.

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