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Negative Externalities

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

negative externalities

Many types of activity give rise to externalities. And these externalities can be positive and negative.


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

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 of a good.
  • 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 an essential building block of 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.

Private Costs and Social Costs

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

Social Benefit   =          Private Benefit + External Benefit

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


Social costs are the total costs incurred by society from an economic action – they include private and external costs

External costs from production

Production externalities are generated and received in supplying goods and services - examples include noise and atmospheric pollution from factories.

External costs from consumption

  • Consumption externalities are generated and received in consumption - examples include 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.

Negative externalities from production – social cost > private cost

Negative externalities from production

Marginal cost or marginal benefit is the change in total cost or benefits that results from an increase in production or consumption by one unit

In the absence of externalities, the private marginal costs of the supplier are the same as the costs for society. But if there are negative externalities, we must add the external costs to the firm’s supply curve to find the social marginal cost curve.

If the market fails to include these external costs, then the private equilibrium output will be Q1 and the price P1 where private marginal cost = private marginal benefit.

From a social welfare viewpoint, we want less output from activities that create an “economic-bad” such as pollution. A socially-efficient output would be Q2 with a higher price P2. At this price level, the external costs have been taken into account. We have not eliminated the pollution – but at least the market has recognised them and priced them into the price of the product.

Economic and Social Welfare

Private economic welfare requires us to consider only the private (or internal) costs and benefits of production and consumption of goods and services.

But if we wish to look at the economic welfare of the whole community (i.e. the social welfare) then we need to calculate the positive and negative externalities and add them to private benefits and costs. Here is a simple numerical example:

A government is considering four possible capital investment projects. It has the resources to finance and implement only one of these projects. The table below shows the estimated value of the private and external costs and benefits that each project is expected to yield:


New city by-pass
(£ million)

New schools
(£ million)

Improvement to an existing airport
(£ million)

New hospitals
(£ million)

Private benefits





Private costs





Positive externalities





Negative externalities





Net private benefit





Net social benefit





Net social benefit may be taken into account by a government when deciding which project offers the best potential return for society as a whole

Negative Externalities and Government Intervention

To many economists interested in environmental problems the key is to internalise external costs and benefits to ensure that those who create the externalities include them when making decisions.

Pollution Taxes

One common approach to adjust for externalities is to tax those who create negative externalities.
  • This is known as making the polluter pay.
  • Introducing a tax increases the private cost of consumption or production and ought to reduce demand and output for the good that is creating the externality.
  • Some economists argue that the revenue from pollution taxes should be ‘ring-fenced’ and allocated to projects that protect or enhance our environment.
  • For example, the money raised from a congestion charge on vehicles entering busy urban roads, might be allocated towards improving mass transport services; or the revenue from higher taxes on cigarettes might be used to fund better health care programmes.

Examples of Environmental Taxes include some of the following

  • The Landfill Tax - this tax aims to encourage producers to produce less waste and to recover more value from waste, for example through recycling or composting and to use environmentally friendly methods of waste disposal.
  • The Congestion Charge: -this is a high profile environmental charge introduced in February 2003. It is designed to cut traffic congestion in inner-London by charging motorists £8 per day to enter the central charging zone.
  • Plastic Bag Tax: A tax on plastic bags in Wales has seen the number given away drop by sizeable amounts according to this news report Since 1 October 2011, there has been a minimum charge of 5p on all single use carrier bags. The Welsh government acted in a bid to encourage re-use of bags and therefore lower demand for single-use free bags. The justification was on economic and environmental grounds:
  • Vehicle excise duty (VED): Also known as ‘road tax’ – VED starts from a theoretical 'nil' rate and accelerating up depending on the carbon emissions of the vehicle

Problems with Environmental Taxes

Many economists argue that pollution taxes can create problems which lead to government failure.

  • Assigning the right level of taxation: There are problems in setting tax so that private cost will exactly equate with the social cost.
  • Consumer welfare effects: Producers may pass on the tax to the consumers if the demand for the good is inelastic and, as result, the tax may only have a small effect in reducing demand. Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on lower-income consumers and leader to a widening of inequalities in the distribution of income.
  • Employment and investment consequences: If pollution taxes are raised in one country, producers may shift to countries with lower taxes. This will not reduce global pollution, and may create problems such as structural unemployment and a loss of international competitiveness.

Externalities and Regulation

  • The government may intervene through the use of regulations and laws.
  • For example, the Health and Safety at Work Act covers all public and private sector businesses. Local Councils can take action against noisy, unruly neighbours and can pass by-laws preventing the public consumption of alcohol. The British government introduced a ban on smoking in public places from July 1st 2007.
  • The European Union has introduced directives on how consumer durables such as cars, batteries, fridges freezers and other products should be disposed of. The onus is now on producers to provide facilities for consumers to bring back their unwanted products.

Carbon Emissions Trading

The EU Emissions Trading Scheme (EUETS) was launched in 2005 and is a market-based mechanism to incentivise reduction of C02 emissions in a cost-effective and efficient manner.

The EU scheme operates through the trade of CO2 emissions allowances. It creates a market in the right to emit C02. One allowance represents one tonne of C02 equivalent. Companies get most permits free now but many electricity generators in Europe will have to pay for all these from 2013.

A cap is set on emissions – this creates the scarcity required for the market. At the end of each year businesses are required to ensure they have enough allowances to account for their installation’s actual emissions. There are heavy fines for those without such permits.

The aim of carbon trading is to create a market in pollution permits and put a price on carbon. In this way, policy can help internalize environmental costs of firms’ production and encourage lower emissions to tackle climate change

In a cap and trade system, the number of available permits would gradually decline. As the price of the permits rises, so the economics of investing in cleaner technologies will change.  The hope is that businesses will look for ways of reducing c02 emissions in the most efficient way possible

Carbon emissions trading

Supply and demand analysis diagrams can be used when discussing carbon trading schemes. The idea is to gradually cut the supply of permits so that the carbon price is sufficiently high to incentivise businesses to look for ways to cut their total emissions in the most cost-efficient way.

Subsidising positive externalities

  • An alternative to taxing activities that create negative externalities is to subsidise activities that lead to positive externalities
  • This reduces the costs of production for suppliers and encourages a higher output
  • For example the Government may subsidise state health care; public transport or investment in new technology for schools and colleges to help spread knowledge and understanding
  • There is also a case for subsidies to encourage higher levels of training as a means to raise labour productivity and improve our international competitiveness.

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