Negative Production

Externality
Unit 5 - Lesson 2

Learning outcomes:
Explain using diagrams and examples, the
concept of negative production externalities
and the welfare loss associated with the
production of the good.
Evaluate using diagrams the use of
government policies and regulations to
correct the externality.

Negative Production Externality

When the production of a good has
additional spillover costs (negative) on the
third party, society.
Examples:
1. Coal producing factories
2. Oil production - leads to oil spills.

Negative Production Externality

Coal Producing Factory China:
S = MPC = Marginal Private Cost:
Represents the cost of the
private coal firm doing business.
MSC = Marginal Social Cost:
Represents the additional cost to
society for the production of the
good.
Private + Social Cost = MSC

 D=MSB - Socially optimal demand

MPC intersects MSB is the Quantity
produced by the Free Market
(Point A)
MSC intersects MSB-D is the
socially optimal amount. Point B is
allocatively efficient.

Negative Production Externality

Q(free market) > Q(socially efficient)
overallocation of resources to the
production of the goods.
Vertical distance between A & C is the
spillover costs to society.
Red triangle - Total Welfare Loss.
For the market to be Allocatively
Efficient - MPC = MSC

Possible Solutions:
Spillover Costs:
Pollution local water
Increase in cancer rates
Birth defects
Can you think of any other
possible spillover costs?

Possible Solutions:
For the market to produce the socially
optimum amount and reach allocative
efficiency:
MPC must decrease - shift left.
Governments Intervention is necessary.
Can you think of any ways
Governments can decrease the
Marginal Private Costs of firms?

Solutions:
Taxes: Implementing taxes on
firms (carbon taxes) increases the
cost of production thus shifting
the MPC towards the MSC.
Advantages:
1.
2.
3.

Reduces the size of the externality shaded area becomes smaller.

Output decreases moving closer to the
socially optimum amount.
internalizes the externality - producers
& consumers pay the cost of the
transaction

Disadvantages:
1.
2.
3.

Knowing amount of tax is

difficult.
Taxing may not deter production.
Assessing the size is extremely
difficult and relies on government
to pay costs

More Solutions
Legislation and Regulation:
Aim is to increase the cost of production for firms thus
decreasing the MPC and moving it closer to the MSC.
Government enacts laws to restrict the amount a
firm/industry can pollute.
Costs the government a lot of money as they create
agencies to oversee - (ex. FDA)
Enforcement is a challenge - corruption.