Negative Production Externalities (Chain of Analysis)

Explain how negative externalities from production can cause market failure

Externalities are spill-over effects from production and consumption for which no compensation is paid. Externalities lie outside the initial market transaction/price.

Examples of negative production externalities include the external costs of pesticides used in intensive farming and damage to ocean beds from industrial fishing.

The over-use of pesticides will pollute rivers and streams which then causes harm to those who use them. Marginal social cost therefore exceeds marginal private cost (MSC>MPC).

If market output supplied is higher than the social optimum then there is market failure and a deadweight loss of social welfare. Some intervention might be needed.