A negative externality on production occurs when the production of a good or service imposes a cost on third parties who are not involved in the production or consumption of the product. Pollution is a common example of a negative externality on production since pollution by a factory imposes a (non-monetary) cost on many people who otherwise have nothing to do with the market for the product that the factory creates.
When a negative externality on production is present, the private cost to the producer of making a product is lower than the overall cost to society of making that product, since the producer doesn't bear the cost of the pollution that it creates. In a simple model where the cost imposed on society by the externality is proportional to the quantity of output produced by the firm, the marginal social cost to society of producing a good is equal to the marginal private cost to the firm plus the per-unit cost of the externality itself.01of 05
Supply and Demand With a Negative Externality on Production
In a competitive market, the supply curve represents the marginal private cost of producing a good for the firm (labeled MPC) and the demand curve represents the marginal private benefit to the consumer of consuming the good (labeled MPB). When no externalities are present, no one other than consumers and producers is affected by the market. In these cases, the supply curve also represents the marginal social cost of producing a good (labeled MSC) and the demand curve also represents the marginal social benefit of consuming a good (labeled MSB).
When a negative externality on production is present in a market, the marginal social cost and the marginal private cost are no longer the same. Therefore, the marginal social cost is not represented by the supply curve and is instead higher than the supply curve by the per-unit amount of the externality.02of 05
Market Outcome Versus Socially Optimal Outcome
If a market with a negative externality on production is left unregulated, it will transact a quantity equal to that found at the intersection of the supply and demand curves, since that is the quantity that is in line with the private incentives of producers and consumers. The quantity of the good that is optimal for society, in contrast, is the quantity located at the intersection of the marginal social benefit and marginal social cost curves. Therefore, an unregulated market will produce and consume more of a good than is socially optimal when a negative externality on production is present.03of 05
Unregulated Markets With Externalities Result in Deadweight Loss
Because an unregulated market doesn't transact the socially optimal quantity of a good when a negative externality on production is present, there is deadweight loss associated with the free market outcome. This deadweight loss arises because the market produces units where the cost to society outweighs the benefits to society, thus subtracting from the value that the market creates for society.
Deadweight loss is created by units that are greater than the socially optimal quantity but less than the free market quantity, and the amount that each of these units contributes to deadweight loss is the amount by which marginal social cost exceeds marginal social benefit at that quantity. This deadweight loss is shown in the diagram above.04of 05
Corrective Taxes for Negative Externalities
When a negative externality on production is present in a market, the government can actually increase the value that the market creates for society by imposing a tax equal to the cost of the externality. This tax moves the market to the socially optimal outcome because it makes the cost that the market imposes on society explicit to producers and consumers, giving producers and consumers the incentive to factor the cost of the externality into their decisions.
A corrective tax on producers depicted above, but, as with other taxes, it doesn't matter whether such a tax is placed on producers or consumers.05of 05
Other Models of Externalities
Externalities don't only exist in competitive markets, and not all externalities have a per-unit structure. That said, the logic applied in the analysis of a per-unit externality in a competitive market can be applied to a number of different situations, and the general conclusions remain unchanged in most cases.