Negative Externalities (Cambridge (CIE) A Level Economics): Revision Note

Negative externalities of consumption occur when consuming a good or service imposes costs on third parties who are not involved in the transaction

Consumers only consider their private costs, ignoring the external costs to society

As a result, the market over-consumes these goods, leading to market failure

If external costs were considered, the socially optimal level of output would be lower

Examples include cigarettes, alcohol, fatty foods and single-use plastics, which impose health or environmental costs on society

The MSC is assumed to equal the MPC, as the externality arises from the consumption (demand) side of the market

The free-market equilibrium occurs at PeQe, where MPB = MSC, representing the private optimum

Because consumers ignore the external costs of consumption, the MPB lies above the MSB

The socially optimal level of output occurs where MSB = MSC, at PoptQopt, which is allocatively efficient

As a result, the market produces too much output, creating over-consumption equal to Qe − Qopt

This generates a welfare loss (deadweight loss) shown by the pink triangle

• To achieve social efficiency, output must fall so that MSB = MSC

• This creates a role for government intervention, such as taxes, regulation or legislation

Negative externalities of production are often created during the production of a good or service

• These external costs arise from the production of the good or service 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 external costs were considered, the socially optimal level of output would be lower

• E.g., the impact of air pollution, water contamination, noise pollution and health problems on local communities

MSB is assumed to equal MPB, as the externality arises from the production (supply) side of the market

The free-market equilibrium occurs at PeQe where MPC = MSB, representing the private optimum

Because firms ignore the external costs of production, the MSC lies above the MPC

The socially optimal level of output occurs where MSC = MSB, at PoptQopt, which is allocatively efficient

Since the market produces Qe instead of Qopt, there is over-production equal to Qe − Qopt

This creates a welfare loss (deadweight loss) shown by the shaded triangle

To achieve social efficiency, output must fall so that MSC = MSB

Government intervention, such as taxes, regulation or legislation, can reduce over-production and move the market closer to the socially efficient outcome