Negative Externalities

A negative externality is a cost that is suffered by a third party as a result of an

economic transaction. In a transaction, the producer and consumer are the first and
second parties, and third parties include any individual, organization, property
owner, or resource that is indirectly affected. Externalities are also referred to as
spillover effects, and a negative externality is also referred to as an external cost.

Some externalities, like waste, arise from consumption while other externalities,
like carbon emissions from factories, arise from production.

Externalities commonly occur in situations where property rights over assets or

resources have not been allocated, or are uncertain. For example, no one owns the
oceans and they are not the private property of anyone, so ships may pollute the
sea without fear of being taken to court. The importance of establishing property
rights is central to the ideas of influential Peruvian economist, Hernando De Soto,
who has widely argued that successful market economies need a widespread
allocation of property rights to enable economies to fully develop.

Showing negative production

externalities
An external cost, such as the cost of pollution from industrial production, makes
the marginal social cost (MSC) curve higher than the private marginal cost (MPC).
The socially efficient output is where MSC = MSB, at Q1, which is a lower output
than the market equilibrium output, at Q.

Net welfare loss

Net welfare loss can exist in two situations. Firstly, it exists when the marginal cost
to society of a particular economic activity, such as manufacturing 200,000
computers, is greater than the marginal benefit to society. Secondly, it can exist
when the marginal benefit of a given economic activity, such as producing
50,000m computers, is greater than the marginal cost.
The first situation can occur when the market produces 'too much', and the second
when it produces 'too little'.

Example
For example, if we consider a manufacturer of computers which emits pollutants
into the atmosphere, the free market equilibrium will occur when marginal private
benefit = marginal private costs, at output Q and price P. The market equilibrium is
at point A. However, if we add external costs, the socially efficient output is Q1, at
point B.

At Q marginal social costs (at C) are greater than marginal social benefits (at A) so
there is a net loss. For example, if the marginal social benefit at A is £5m, and the
marginal social cost at C is £10m, then the net welfare loss of this output is £10m -
£5m = £5m. In fact, any output between Q1 and Q creates a net welfare loss, and
the area for all the welfare loss is the area ABC.

Therefore, in terms of welfare, markets over-produce goods that generate external

costs.
 Remedies
Market Based Solutions:
Market-based solutions try to manipulate market forces to reduce the externality,
by exploiting the price mechanism. One such market-based solution is to extend
property rights so that third parties can negotiate with those individuals or
organizations that cause the externality. British economist and Nobel Prize winner,
Ronald Coase argued that the establishment of property rights would provide an
efficient solution to the problem of externalities. As long as one party can establish
a property right, there will be a bargaining process leading to an agreement in
which externalities are taken into account.

If property rights cannot be established, such as with the air, sea, or roads, then the
only two options are:

 We learn to live with externalities, or:

 Government intervenes on our behalf through taxes or direct controls and
regulations, such as:

1. Taxing polluters, such as carbon taxes, or taxes on plastic bags.

2. Subsidizing households or firms to be non-polluters, such as giving grants for
home insulation improvements.
3. Selling permits to pollute, which may become traded by the polluters.
4. Forcing polluters to pay compensation to those who suffer, such as making noise
polluting airports pay for double-glazing.
5. Road pricing schemes, such as the Electronic Road Pricing (ERP) system in
Singapore, which is a pay-as-you-go, card-based, road-pricing scheme.
6. Providing more information to consumers and producers, such as requiring that
tickets to travel on polluting forms of transport, especially air travel, should
contain information on how much CO2 pollution will be created from each journey.
7. The adoption of policies emerging from research by behavioral economists - often
shortened to 'nudge' theory. This type of approach looks at influencing choices
individuals make by nudging them towards more effective decision making.

Negative consumption externalities

When certain goods are consumed, such as demerit goods, negative effects can
arise on third parties. Common example include cigarette smoking, which can
create passive smoking, drinking excessive alcohol, which can spoil a night out for
others, and noise pollution.

For example, if an individual plays very loud music in their house they are likely to
reduce the benefit to their neighbors of owning the house and living in it.

Another important example of a negative consumption externality if that of road

congestion. As individuals 'consume' road-space they reduce available road-space
and deny this space to others.

Trends in alcohol consumption

As the table indicates, consumption of alcohol (in the UK) has declined in recent
years, with a reduction in the percentage of people regularly consuming alcohol
falling from 64% to 57% between 2005 and 2016.