Negative Externalities

Economic activities can impose unaccounted-for costs on society, known as negative externalities. These inefficiencies often lead to government interventions and have widespread implications, affecting issues as significant as climate change and public health.


  • Externalities: Economic side effects or by-products that affect an uninvolved third party; can be either positive or negative.
  • Negative Externalities: Costs that are suffered by a third party as a consequence of an economic transaction they were not a party to.

Types of Negative Externalities

  • Production Externalities: Occur in the production phase of a good or service. Example: Pollution from a factory affecting nearby residents.
  • Consumption Externalities: Occur during the consumption of a good or service. Example: Secondhand smoke.


  • Non-Excludability: Affected parties cannot easily opt out of suffering the externality.
  • Non-Rivalry: The cost imposed on one does not diminish the cost imposed on another.

Key Concepts

  • Marginal Social Cost (MSC): The total cost society pays for the production of an extra unit of a good or service.
  • Marginal Private Cost (MPC): The cost that the producer incurs in the production of an extra unit of a good or service.
  • Social Welfare: The overall well-being of a society, often diminished by negative externalities.

Classic Examples

  • Air Pollution: Industries emitting pollutants, affecting public health.
  • Overfishing: Depleting fish stocks affects future fishing opportunities for all.
  • Traffic Congestion: Individual car use leads to increased travel time for all.


  • Pigouvian Taxes: Taxes designed to correct the negative externality by aligning private cost with social cost.
  • Coase Theorem: Suggests that under perfect property rights and zero transaction costs, externalities can be efficiently internalized.

Market Failure

Incomplete Markets: Markets that do not account for externalities fail to allocate resources efficiently.

Policy Solutions

  • Regulation: Government intervention to limit or ban activities causing externalities.
  • Cap-and-Trade: Allowing firms to buy and sell rights to emit a set amount of a pollutant.

Global Perspective

  • Climate Change: A quintessential example of global negative externalities, impacting nations unequally.
  • Global Commons: Resources like oceans and atmosphere, shared globally, often suffer from the “Tragedy of the Commons.”

Economic Theories Involved

Welfare Economics: Studies how the allocation of resources affects social welfare.


Income Inequality: Those with fewer resources often disproportionately suffer from negative externalities.

Moral and Ethical Considerations

Intergenerational Equity: Future generations cannot participate in decisions affecting them, such as environmental degradation.