A negative externality occurs when you do something that imposes costs on another person without reimbursing that person for the harm that you’ve done to them. So let’s say that you play the radio really loud at night and it makes it hard for your next-door neighbor to study for his or her exam the next morning and so then they get a bad grade. You’ve imposed costs on that person by your actions and so it’s not just people that can create negative externalities we could also have companies do that with things like pollution. So let’s say that I happen to live near a lead smelting company and so they smelt lead and the tailings from the lead can create pollution that contaminates the soil and it can also contaminate water. Let’s say that there is a river nearby and I live there and I like to go fishing in that river but because of the lead smelting process it ends up killing some of the fish and so I can catch fewer fish because of this lead smelting process. So it’s basically imposing a cost on me. Also, it could be health costs and so forth but the bottom line is that the lead smelter is taking an action, it’s producing some goods that are creating a cost for me but I’m not being reimbursed and I’m not being consulted or anything like that.
So I want to graph this out for you to see basically how this would work in a free market. How a negative externality would occur and what it would look like. So let’s say we’ve got the price of smelting lead and then we have the quantity of lead to be smelted. So we have our downward sloping demand curve and the demand is also the marginal social benefit so you can think of that as the marginal social benefit and you might think it what is the social benefits of the smelting lead. Well, we used that in batteries and stuff like that so there is some benefit to smelting lead and so from a social standpoint we can look at our marginal social benefit. Then we can also look at the marginal social cost. The optimal amount of lead that should be smelted from the standpoint of society is going to occur where the marginal social benefit is equal to the marginal social cost so that’s going to be right here in point E1.
That’s going to be our optimal quantity of lead from a social standpoint so we’ll call it the socially efficient or socially optimal amount of lead and let’s say that that’s 100,000 tons of lead that are smelted and that is optimal. Now here is the nature of the externality for the lead smelting company their cost is lower than the marginal social cost because they only consider here’s their marginal private cost and by private cost I mean the cost to the smelter itself. So that company itself they’re not thinking necessarily about what’s happening to me with the fish I catch or things like that. They’re just looking at, for their firm what is the marginal cost of their firm of smelting an additional ton of lead and so their marginal private cost is lower than the social cost and the reason is that the social cost includes two things, it includes the private cost the cost to the lead smelting company + the external cost that’s the cost to other people in society aside from the smelting company. So it’s those two things but the marginal private cost does not include the external costs.
What does that mean? That means that in a free market the amount of lead that is actually going to be smelted is going to be at point Q, it’s going to be some amount larger, let’s just say that it’s 130,000 tons and the reason is that when the lead smelting company is making the decision of how much lead should we smelt? They’re going to look at their private costs (The costs to them) the marginal cost of smelting an additional ton and they’re gonna go where the marginal private costs equal to their benefit, that’s the amount that they’re gonna smelt. So this is going to be the equilibrium. This is the amount produced by the free market the amount of lead that’s going to be smelted. Now you see that this is higher, the amount that is produced by the free market. We can see that the amount produced by the free market is actually higher. So basically from a social standpoint, there’s a lot more lead that’s being smelted than what is optimal and from the social standpoint, we’re considering all the costs and benefits to everybody not just for that particular firm and so we’re smelting too much lead.
The reason is that this smelting company they’re making the decision of whether to do this, they are not considering the cost imposed on people like me are you. They’re thinking about their own private costs, their own marginal cost. Now that is going to cause them to produce a quantity of lead that is higher than what would be socially efficient. So this is a market failure this is a negative externality here and there are several ways to address that and one is with the Pigovian tax this is a corrective tax there’s also you could have marketable permits or cap and trade you’ve probably heard of and then also there’s the thing called Coasian bargaining that we’ll talk about in some of the articles to come.