Negative Production Externalities

A negative production externality arises when producing a good or service imposes a harmful effect on persons or resources not involved in the market transaction. Because this external cost is not fully borne by the producer or reflected in the market price, private production decisions understate the true cost to society.

What makes the externality negative and production-based

The effect must originate from production, reduce the welfare of third parties, and operate without adequate compensation through the market. It is negative because it creates a real social cost, such as poorer health, ecological damage or depletion of a shared environmental resource.

• Pollution of air or water by a factory is a production externality when affected communities bear part of the damage.
• Noise, waste heat and greenhouse gas emissions can qualify when their environmental costs fall outside the producer's accounts.
• A mere fall in a rival firm's profit due to market competition is generally a pecuniary effect, not an environmental externality.

Divergence between private and social cost

The producer considers its marginal private cost, such as labour, energy and equipment expenses, but may ignore the marginal damage imposed on others. Therefore, marginal social cost equals marginal private cost plus marginal external cost.

• When market price reflects only private cost, the good tends to be produced at a quantity greater than the socially efficient level.
• The resulting misallocation is a form of market failure, since the price signal does not incorporate the full environmental cost.

Internalising the external cost

Policy seeks to make producers account for the damage they cause. Instruments include Pigouvian taxes, emission standards, tradable pollution permits, liability rules and clearer property rights, chosen according to monitoring capacity and the nature of the pollutant.

• A corrective tax should ideally reflect the marginal external damage at the socially efficient output.
• Regulation may be preferable where damages are severe or emissions are difficult to price reliably.