Market Failure: Negative Externalities (AQA A Level Economics)

• Externalities occur when there is an external impact on a third party not involved in the economic transaction
  • These impacts can be negative or positive and are often referred to as spillover effects
  • These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)
    
    
• External costs occur when the social costs of an economic transaction are greater than the private costs
  • A private cost for the producer is what they actually pay to produce a good/service
  • An external cost (negative externality) is the damage not factored in to the economic activity (for example, generating air pollution when producing electricity)
  • Private cost + external cost = social costs
    
    
• External benefits occur when the social benefits of an economic transaction are greater than the private benefits
  • A private benefit for the consumer is what they actually gain from consuming a good/service
  • An external benefit (positive externality) is the benefit not factored in to the economic activity (for example, someone who studies law enjoys private benefits but society benefits from having strong legal institutions)
  • Private benefit + external benefit = social benefits

• Negative externalities of production are often created during the production of a good/service
  • The externalities are caused by producer supply and result in a negative external impact on a third party
    
    
• As only the private costs are considered by producers and not the external costs, firms will over-produce these goods and services, causing market failure
  • If the external costs were considered, the quantity of goods and services produced would decrease, and they would be sold at a higher price
  • E.g The impact of air pollution, water contamination, noise pollution and health problems in local communities from 
    
    

Diagram: Negative Externality of Production

External costs of production results in an over-production equal to Q_opt - Q_e

Diagram analysis

• The marginal social benefit (MSB) is assumed to equal the marginal private benefit (MPB) as the focus is on the producer (supply) side of the market
• The larger the external costs in production, the larger the gap between the marginal private cost (MPC) and the marginal social cost (MSC)
• The optimal allocation of resources for society, would generate an equilibrium where MSB = MSC
• This is at P_optQ_opt which is allocatively efficient
• There is no market failure at this equilibrium
  
  
• The free-market allocates resources at the private optimum as firms fail to take into account the full social costs (negative externalities) from production, resulting in a welfare loss
• This is shown at P_eQ_e where the MPC = MSB
  
  
• As the MPC are less than the MSC, there is an over-production equal to Q_e - Q_opt
• At any quantity produced beyond Q_opt, the MSC is greater than the MSB, resulting in a deadweight loss to society (pink triangle)
• To be socially efficient, factors of production should be reallocated to producing other goods/services
• There is an opportunity for government intervention (indirect taxes, legislation, regulation, etc.), to force this market to be more socially efficient and reduce the overall welfare loss to society

• Negative externalities of consumption are often created during the consumption of a good/service
  • The externalities are caused by consumer demand and result in a negative external impact on a third party
    
    
  • As only the private costs are considered by consumers and not the external costs, individuals will over-consume these goods and services, causing a market failure
    • If the external costs were considered, the quantity of goods and services demanded would decrease, and they would be sold at a lower price
    • Common examples of negative externalities from consumption include cigarettes, alcohol, fatty foods and single-use plastic products

Diagram: Negative Externality of Consumption 

External costs of consumption result in overconsumption, as shown by the gap between Q_opt and Q_e

Diagram analysis

• The MSC is assumed to be equal to the MPC as the focus is on the consumer (demand) side of the market
• The larger the external costs in consumption, the larger the gap between the MPB and the MSB
• The optimum allocation of resources for society, would generate an equilibrium where MSB = MSC
• This is at P_optQ_opt which is allocatively efficient
• There is no market failure at this equilibrium
  
  
• The free-market allocates resources at the private optimum as consumers fail to take into account the negative externalities from consumption, resulting in a welfare loss
• This is shown at P_eQ_e where MPB = MSC
  
  
• As the MPB are greater than the MSB, there is an over-consumption of goods from Q_opt - Q_e
• At any quantity consumed beyond Q_opt, the MSC is greater than the MSB, resulting in a deadweight loss (DWL) to society (pink triangle)
• To be socially efficient, fewer factors of production should be allocated to producing this good/service
• There is an opportunity for government intervention (indirect taxes, legislation, regulation, etc.), to force this market to be more socially efficient and reduce the overall welfare loss to society