An externality is a spill over from an economic activity. It is often referred to as a by-product of the market mechanism (supply equals demand).Negative externalities are often viewed as examples of market failure, in other words, the market mechanism creates a level of consumption / production that is higher than society desires.
A negative externality occurs when the by-product is viewed as having a social cost. For instance, when a car is driven it creates air pollution. This air pollution can have very harmful effects on other people. Interestingly, you - as an individual - do not account for this in the costs of driving, however society pays the costs of dealing with air pollution. Therefore, car pollution is a negative externality.
This implies that a negative externality occurs when the social cost is greater than the private cost. If the two values were the same, then there would not be a negative externality.
Negative externalities can be created through either the consumption or production of a good.
A consumption created negative externality is illustrated below;
The externality is created because the marginal private benefit (individual's demand curve) is greater than the marginal social benefit (society's demand curve). Therefore, society would like a quantity Q1, while the individual would prefer quantity Q2.
A producer created negative externality is illustrated below
The externality is represented by the shaded triangle. It is created because the marginal private cost is less than the marginal social cost. Therefore, the marginal private costs is further to the right.
The explanation of why the curves are not the same will depend on the particular market.
The policy of reducing / removing the externality would need to shift the private costs / benefits towards the social costs / benefits.
Available policies are broadly divided into;
- Market solutions - change the costs of the activity to account for the negative externality. This usually involves the use of charges, taxes or subsidies.
- Regulation / legislation - this policy involves the government introducing legislation that regulates the externality to reduce it.
- Property rights - for some negative externalities, such as, pollution, if somebody had ownership rights to the air, sea etc., then they could take the polluters to court for compensation. The provision of property rights would give individuals ownership rights on the sea, air etc.,
- Tradeable pollution permits - a modern development in the area of controlling negative externalities has been the use of tradeable pollution permits. These can be used to control the degree of structural change and focus on tackling the worst culprits.