In this video we walk through the absolutely essential diagram showing negative externalities from production.

Externalities are spill-over effects from production and/or consumption for which no appropriate compensation is paid to one or more third parties affected

Key Exam Point: Externalities lie outside the initial market transaction and (without state intervention), they are not fully reflected in the market price.

What is the essential point about negative externalities and market failure?

The key problem is that often, economic agents operating in their own self-interest do not take account of the costs their decisions impose on others. The market fails to price negative externalities properly leading to misallocation of resources from a social perspective.