Externality
What is Externality?
An externality is a cost or benefit imposed on a third party who is not directly involved in the production or consumption of a good or service.
Externalities arise when the actions of producers or consumers affect others who are not part of the market transaction. Negative externalities, like pollution, impose costs on others, while positive externalities, like education, create benefits. Externalities can lead to market failure and inefficient outcomes.
Externality: a worked example
A paper mill's private marginal cost is MPC = 2 + 0.5Q per ton and it sells into demand P = 20 − Q, so the unregulated market produces 12 tons at $8. If each ton also imposes $3 of cleanup costs on downstream water users, marginal social cost is MSC = 5 + 0.5Q and the efficient output is 10 tons, so the market overproduces by 2 tons and generates ½ × 2 × $3 = $3 of deadweight loss. A $3 per-ton corrective tax makes the mill face the full social cost and moves output to 10 tons.
The mistake students make with externality
Students draw a negative production externality by shifting the market supply curve left to the social-cost curve, as if firms already paid the external cost, and then read the market outcome off that curve. Supply stays put at marginal private cost and marginal social cost is drawn as a separate curve above it, because the firm still trades where private cost meets private benefit; the gap between that quantity and the smaller efficient quantity is the whole point of the diagram.
Externality questions
What is an example of a negative externality?
Pollution from a coal-fired power plant is a negative externality, because people living downwind bear health and cleanup costs that neither the plant nor its electricity customers pay for. Since that cost sits outside the price, the market produces more electricity than is socially efficient.
Why do externalities cause market failure?
Externalities cause market failure because buyers and sellers decide using private costs and benefits only, so goods with negative externalities are overproduced and goods with positive externalities are underproduced relative to the socially efficient quantity. The gap between the market quantity and the efficient quantity shows up as deadweight loss.
What is the difference between a positive and a negative externality?
A negative externality imposes an uncompensated cost on a third party, so marginal social cost exceeds marginal private cost and the market overproduces, while a positive externality confers an uncompensated benefit, so marginal social benefit exceeds marginal private benefit and the market underproduces. The standard corrections are a per-unit tax in the first case and a per-unit subsidy in the second.
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Related terms
Common comparisons
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