Negative Externalities

Economics: IB Diploma, topic 1.4.3

Negative Externalities

When firms account for external costs of production (in addition to their private costs of production) when making output decisions, this is known as internalizing an externality.

How to analyze social costs (externalities)

Economists illustrate the social costs of production with a demand and supply diagram.
The social costs include the private costs of production that a company incurs and the external costs of pollution that pass on to society.

Demand and supply example

This diagram shows the demand and supply for manufacturing refrigerators.

Demand and supply example

The demand curve (D) shows the quantity demanded at each price.
The supply curve (S_private) shows the quantity of refrigerators that all firms in the industry supply at each price assuming they are taking only their private costs into account and they are allowed to emit pollution at zero cost.
Accounting for additional external costs of $100 for every unit produced, the firm’s supply curve will be S_social. The equilibrium will move from E₀ to E₁.

Additional external costs

In this example, we have assumed additional external costs for every refrigerator produced. Why might this be the case?
As a by-product of the metals, plastics, chemicals and energy that refrigerator manufacturers use, some pollution is created.
Let’s say that, if these pollutants were emitted into the air and water, they would create costs of $100 per refrigerator produced. These costs might occur because of adverse effects on human health, property values, or wildlife habitat, reduction of recreation possibilities, or because of other negative impacts.
In a market with no anti-pollution restrictions, firms can dispose of certain wastes absolutely free.

Output decisions

The supply curve is based on choices about production that firms make while looking at their marginal costs, while the demand curve is based on the benefits that individuals perceive while maximizing utility.
If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole.
Thus, if no externalities existed, the interaction of demand and supply will coordinate social costs and benefits.

Market failure

When the externality of pollution exists, the supply curve no longer represents all social costs. Because externalities represent a case where markets no longer consider all social costs, but only some of them, economists commonly refer to externalities as an example of market failure.
When there is market failure, the private market fails to achieve efficient output, because either firms do not account for all costs incurred in the production of output (negative externality) and/or consumers do not account for all benefits obtained (a positive externality).

Key takeaway

If firms are required to pay the social costs of pollution (and internalize external costs), they would create less pollution but produce less of the product and charge a higher price.

Test yourself on Negative Externalities

If the private market fails to achieve efficient output because firms do not account for all costs incurred in the production of output, what does this result in?
If a firm decides to factor in all costs of production (including external costs), what happens to its supply curve?

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