The Impacts of Positive and Negative Externalities
A negative externality is an example of market failure. In such a situation, the full private cost is not recognized by the
producers. In this case, firms’ private costs are not all present in the price of their product, and they spill out to society,
forcing consumers to bear some, most, or all of the cost.
Spillover Costs
When firms have spillover costs, they shift some of their costs onto the community. When this occurs, a firm’s marginal
cost decreases, thereby reflecting an inaccurate supply curve. The spillover costs underestimate the costs of production,
and the eventual outcome may be overproduction of the good and overuse of the resources. The firm’s spillover costs
also create nonmonetary costs. These types of costs are usually associated with health problems or environmental pollu-
tion that result from a firm’s overuse or overproduction of resources.
Consider this example: Dan lives in a house that has a wonderful view of the city skyline. Dan enjoys coming home
every day and taking in the beautiful view. One day a building contractor notifies Dan that his firm will construct a new
high school in front of his home. Dan initially digests the news with little concern, but over the next few months, he
begins noticing that his precious view is beginning to disappear. Once the construction is complete, Dan’s view will
no longer be of a skyline; rather, it will be a view of the side of the gym. This is an example of a negative externality.
Pollution is another example of a negative externality. If a firm begins producing a good and is polluting the water in
its area and ignoring its costs, this firm is creating a negative externality. Negative externalities in this situation can be
graphed as shown in Figure 11-2. The graph illustrates the marginal cost curve above the supply curve. The reason for
this is because the firm is not incurring all of the costs. Some of its costs are borne by society, and this actually allows
the firm to produce more because of a low monetary cost.
Figure 11-2The graph in Figure 11-2 shows that if the producer is creating a negative externality, the price to make its product is
relatively low because it is not paying all of the costs. This is indicated at Qp and P on the graph. If the producer were
to bear all costs, the cost of production would rise and the quantity of the good would decrease.
The government can sometimes regulate what and how much is produced by a firm. If that is the case, you would use
the graph to illustrate the government regulation. The graph in Figure 11-3 illustrates another government option for
limiting production: taxation.
QP QuantityPriceQSPPSS (private cost only)DS (all costs considered) = MSCThe Government’s Role, Externalities, and Efficiency