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Wize AP Microeconomics Textbook > Externalities/Market Failures

Negative Externalities

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Negative Externalities

A negative externality is when the consumption of a good has a negative effect or external cost on society. This is considered a market failure because the cost to society is not equal to the benefit to society. Example: Cigarettes


 Marginal Social Cost= Marginal (Private) Cost + Marginal External Cost\boxed{\text\ Marginal\ Social\ Cost =\ Marginal\ \left(Private\right)\ Cost\ +\ Marginal\ External\ Cost}
  • Marginal (Private) Cost - cost for the firm making the product (cigarette company). It is represented by the supply curve.
  • Marginal External Cost (or pollution cost) - cost to the environment and other members of society (people inhaling second hand smoke)
  • Marginal Social Cost - the full cost to society
  • Private Value or Benefit - this the benefit to the consumer from consuming the product. It is represented by the demand curve.

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  • The total surplus is the consumer surplus plus the producer surplus.
  • The consumer surplus is the area above the price but below the demand.
  • Normally, producer surplus is the area below the price but above the supply. However, when there's externalities, to find the producer surplus we use the following formula:
 Producer Surplus= Amount Received by Producers−Social Cost to Society\boxed{\text\ Producer\ Surplus =\ Amount\ Received\ by\ Producers-Social\ Cost\ to\ Society}

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Private Equilibrium Socially Optimal Quantity (Allocative Efficiency)

Consumer Surplus
A+B+C+D
D

Amount Received by Producers
E+F+G
A+E+B+F

Social Cost to Society
F+G+B+C+H
B+F

Producer Surplus
+E-B-C-H
A+E

Total Surplus
A+D+E-H
D+A+E
  • Benefit by moving to socially optimal quantity =
    H
  • Negative externalities are
    over
    produced and
    under
    priced at the private equilibrium.






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Example: Negative Externality

When there is a negative production externality

A) the marginal social cost is lower than the marginal (private) cost
B) the marginal social cost is equal to the marginal (private) cost
C) the marginal cost is equal to the marginal external cost
D) the marginal social cost is higher than the marginal (private) cost


D
Marginal social cost = marginal cost + marginal external cost
Therefore marginal social cost will always be higher.

Practice: Negative Externality

An example of a negative externality is