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Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid.

Externalities are third party effects arising from production and consumption of goods and services for which no appropriate compensation is paid.

Externalities occur outside of the market i.e. they affect people not directly involved in the production and/or consumption of a good or service. They are also known as spill-over effects.

Economic activity creates spill over benefits and spill over costs – with negative externalities we focus on the spill over costs

Negative externalities occur when production and/or consumption impose external costs on third parties outside of the market for which no appropriate compensation is paid.

The Importance of Property Rights

  • Property rights confer legal control or ownership
  • For markets to operate efficiently, property rights must be protected – perhaps through regulation
  • Put another way, if an asset is un-owned, no one has an incentive to protect it from abuse. The right to own property is essential in a market-based system
  • Failure to protect property rights may lead to what is known as the Tragedy of the Commons - examples include the over use of common land and the long-term decline of fish stocks caused by over-fishing which leads to long term permanent damage to the stock of natural resources.

Social Costs and Social Benefits

A government gives its approval for the building of a private airport because the airport would be socially beneficial. In making its decision it calculates private costs at $700m, private benefits at $800m and external costs at $200m. Given this data, the external benefits of the must be more than $100m because approval would require social benefit > social cost.

The difference bewteen private and social costs

Private costs are the costs faced by the producer or consumer directly involved in a transation.

The existence of externalities creates a divergence between private and social costs of production and the private and social benefits of consumption.

Social Cost = Private Cost + External Cost

When negative production externalities exist, social costs exceed private cost. This leads to over-production and market failure if producers do not take into account the externalities.

External costs from production

Production externalities are generated and received in supplying goods and services - examples include noise and atmospheric pollution from factories. And also discharges of waste.

External costs from consumption

  • Consumption externalities are generated and received in consumption – e.g. pollution from driving cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution created by loud music being played in built-up areas.
  • Negative consumption externalities lead to a situation where the social benefit of consumption is less than the private benefit.
Overview of negative externalities
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