6.3 Negative Externalities

What is a negative externality?

A negative externality occurs when a third party not involved in a transaction bears a cost from it. Because producers or consumers ignore this external cost, the market's private (supply) cost understates the social cost. This causes the good to be overproduced relative to the socially optimal quantity.

Marginal social cost vs. marginal private cost

Marginal Social Cost (MSC) = Marginal Private Cost (MPC) + Marginal External Cost (MEC). With a negative externality, the MSC curve lies above the supply (MPC) curve. The socially optimal quantity occurs where MSC = MB (demand), which is less than the market equilibrium quantity where MPC = MB.

Fixing the overproduction: government correction

Government can correct negative externalities via a per-unit tax (Pigouvian tax) equal to the external cost, shifting supply up to MSC, reducing quantity to the efficient level. Other tools include regulation (quantity limits, standards) and tradable permits. Without correction, there's a deadweight loss from overproduction.

Key terms

Negative externality

An uncompensated cost imposed on a third party not involved in the transaction.

Marginal Social Cost (MSC)

MPC + marginal external cost; the true cost to society of producing one more unit.

Effect on market equilibrium

Negative externalities cause overproduction because MPC understates MSC.

Pigouvian tax

A per-unit tax equal to the marginal external cost, shifting supply to MSC and correcting overproduction.

Deadweight loss from negative externality

Loss of efficiency from producing units where MSC exceeds marginal benefit.

Try an AP-style question

What is the MSC per unit?

1. $25
2. $20
3. $15
4. $5