Externalities: Negative and Positive Production and Consumption Effects
An externality is a cost or benefit from an economic transaction that falls on a third party not directly involved in it, causing a divergence between private cost or benefit (borne by the producer or consumer) and social cost or benefit (borne by society as a whole).
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Method
- Identify the type of externality first: production or consumption, and negative or positive, since this determines which diagram to draw.
- For a negative production externality, draw MPC and MSC, with MSC above MPC by the value of the externality, and MPB=MSB as the demand curve; the free market equilibrium Qm occurs where MPC=MPB, while the socially optimal quantity Qopt (lower than Qm) occurs where MSC=MSB.
- For a positive consumption externality, draw MPB and MSB, with MSB above MPB, and MPC=MSC as the supply curve; the free market equilibrium Qm (lower than the social optimum) occurs where MPC=MPB, while Qopt occurs where MSC=MSB.
- In both cases, identify and describe the welfare loss (deadweight loss) triangle: it lies between Qm and Qopt, bounded above and below by the two curves that diverge (MSC and MSB for a negative externality; MSB and MSC for a positive one), representing the net loss to society from producing or consuming the 'wrong' quantity.
- State the general rule clearly: the free market overproduces goods with negative externalities and underproduces goods with positive externalities, relative to the socially optimal quantity.
- For an evaluation question, note that quantifying an externality in money terms (e.g. valuing air pollution or a health benefit) is difficult and uncertain, and that any government intervention to correct it carries its own costs and risk of government failure.
Worked example
In a market with a negative production externality, marginal private cost is MPC = 2 + 0.5Q and marginal social cost is MSC = 2 + Q. Demand equals both marginal private and marginal social benefit: MPB = MSB = 10 - 0.5Q. Calculate the free market equilibrium quantity and the socially optimal quantity, and state which is larger.
- Find the free market equilibrium Qm by setting MPC = MPB: 2 + 0.5Q = 10 - 0.5Q.
- Solve: 0.5Q + 0.5Q = 10 - 2, so Q = 8. The free market produces Qm = 8.
- Find the socially optimal quantity Qopt by setting MSC = MSB: 2 + Q = 10 - 0.5Q.
- Solve: Q + 0.5Q = 10 - 2, so 1.5Q = 8, giving Q = 5.33 (to two decimal places).
- Compare the two: Qm = 8 is larger than Qopt = 5.33, confirming the free market overproduces relative to the social optimum, with the welfare loss triangle lying between Q = 5.33 and Q = 8.
Practice questions
Try each question, then tap to reveal the answer.
Q1Define an externality.Show answer
Answer: A cost or benefit from an economic transaction that falls on a third party not directly involved in that transaction.
Q2State the difference between marginal private cost and marginal social cost.Show answer
Answer: Marginal private cost is the cost to the producer of making one more unit; marginal social cost also includes any additional cost imposed on third parties, such as pollution.
Q3Give an example of a negative consumption externality.Show answer
Answer: Passive smoking, where a smoker's consumption harms the health of nearby non-smokers.
Q4Give an example of a positive production externality.Show answer
Answer: A firm training its staff, some of whom later move to other employers and take their improved skills with them, raising productivity elsewhere in the economy.
Q5State the general rule for how a free market treats a good with a negative externality.Show answer
Answer: The free market tends to overproduce it, since producers and consumers do not bear the full social cost of production or consumption.
Q6What does the welfare loss triangle on an externality diagram represent?Show answer
Answer: The net loss of welfare to society caused by producing or consuming at the free market quantity rather than the socially optimal quantity.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Using a diagram, explain why the free market is likely to overproduce a good that generates a negative production externality.
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Evaluate the view that government intervention is always the best way to correct a negative externality.
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See real A Level Economics past-paper questions, with official mark schemes →
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