IB Economics SL & HLTopic 2.8 — Externalities & Common Pool ResourcesPaper 1 & 2Diagram skill~12 min read
Negative Externalities and Demerit Goods
Somebody makes something, somebody buys it, both are pleased. Meanwhile a third person breathes the smoke, cleans up the litter or loses a night’s sleep — and pays for it without ever agreeing to. That uncounted cost is why the market makes too much.
📚 What you need to know
A negative externality is a cost falling on a third party who is not part of the transaction.
Of production: the cost comes from making the good, so the supply side splits and MSC sits above MPC.
Of consumption: the cost comes from using it, so the demand side splits and MSB sits below MPB.
Either way the market over-provides: Qe is bigger than Qopt.
The welfare loss triangle sits between Qopt and Qe, pointing at Qopt.
Demerit goods are goods with external costs in consumption, usually harmful and often addictive.
Fewer factors of production should be going into these goods.
Negative externalities of production
A steel plant pays for iron ore, electricity and workers. It does not pay for the dirty air over the town, the damaged crops or the extra asthma cases. Those are real costs, they are just landing on somebody else’s account.
So the firm’s own cost curve, MPC, sits below the true cost to society, MSC. The vertical gap between them is the external cost per unit. The firm produces where its private cost meets demand, which is further right than society would choose.
Only supply splits here. Demand stays as one line, because using steel does not harm anyone extra — making it does.
Read the triangle out loud: between Qopt and Qe every extra unit costs society more than it is worth to anyone. All those little losses added together are the triangle.
Negative externalities of consumption
Now the harm comes from the using, not the making. A cigarette hurts the smoker’s neighbours through second-hand smoke and hurts taxpayers through healthcare costs. Producing it was not the problem.
So this time demand splits. MPB is what the buyer thinks it is worth. MSB is lower, because society is quietly paying part of the bill. The market lands where MPB meets supply, which is again too far to the right.
Compare the two diagrams. Production splits supply and the optimum price is higher; consumption splits demand and the optimum price is lower.
Spot the difference in one glance. If the extra curve is drawn above the original, it is a cost curve (MSC). If it is drawn below, it is a benefit curve (MSB). Two curves above and below the same original never happens.
Demerit goods
A demerit good is a good with external costs in consumption. Alcohol, tobacco, gambling, sugary drinks. Two extra features usually come with them.
They tend to be harmful to the user as well as to others, and often addictive.
Buyers usually underestimate the harm to themselves, which is a second reason they over-consume.
Economists normally reserve “demerit good” for goods used in consumption. Smoke from a power station is a by-product of production, not a good anyone buys, so electricity is not a demerit good even though generating it can be dirty.
🧩 Drawing a negative externality, step by step
Decide: is the harm from making it or using it? That tells you which curve splits.
Draw the two ordinary curves and label the free market PeQe where MPB = MPC.
Add the third curve: MSC above MPC, or MSB below MPB.
Find Qopt where MSB meets MSC, and drop a line to the axis.
Shade the triangle between Qopt and Qe. Point at Qopt.
Write the sentence: over-provision equal to Qe − Qopt, so fewer resources should go into this good.
Worked examples
WORKED EXAMPLE
Welfare loss from a polluting factory
A chemical plant produces 120,000 tonnes. The socially optimum output is 90,000 tonnes. At the free market output, MSC is $65 and MSB is $45. Calculate the welfare loss. [2]
Step 1: Base of the triangle120,000 − 90,000 = 30,000 tonnesStep 2: Height at Qe65 − 45 = $20Step 3: Area of the triangle(30,000 × 20) ÷ 2 = 300,000Welfare loss = $300,000this is value society loses on the units between Qopt and Qe
WORKED EXAMPLE
Total external cost
Each packet of cigarettes creates an external cost of $4 through second-hand smoke and healthcare. 250,000 packets are sold. Calculate the total external cost and explain what it means. [3]
Step 1: Multiply out4 × 250,000 = 1,000,000Total external cost = $1 millionStep 2: Say who pays it
Not the smoker and not the tobacco firm — it lands on non-smokers and on taxpayers.
total external cost is not the same as the welfare loss; the welfare loss is only the triangle
WORKED EXAMPLE
Over-consumption of a demerit good
A country consumes 500,000 litres of alcohol. The socially optimum quantity is 440,000 litres. At the free market quantity MPB is $30 and MSB is $15. Calculate the welfare loss and state one policy response. [4]
Step 1: Over-consumption500,000 − 440,000 = 60,000 litresStep 2: Gap at Qe30 − 15 = $15Step 3: Welfare loss(60,000 × 15) ÷ 2 = 450,000Welfare loss = $450,000Step 4: A policy
An indirect tax of $15 per litre would move consumption towards 440,000 litres.
the ideal tax equals the external cost per unit at the optimum
💡 Exam tip
Write out the full labels: D = MPB = MSB on a production diagram, S = MPC = MSC on a consumption one. It proves you know which side splits.
Always mark both quantities and both prices. Four labels, every time.
Say clearly whether Popt is above or below Pe. Production diagrams push price up, consumption diagrams push it down.
Follow the diagram with the resource sentence: fewer factors of production should be allocated to this good.
Use real examples — air pollution, river contamination, litter, second-hand smoke, traffic noise.
Evaluation: mention that external costs are extremely hard to measure in money, so the “right” tax is a guess.
⚠ Common mix-up
Splitting demand for a production externality. Pollution from a factory is a cost of making it, so supply splits.
Drawing MSC below MPC. A negative externality adds cost, so the social curve is always the higher one.
Confusing total external cost with welfare loss. Total external cost is a rectangle of harm; welfare loss is a triangle of missed value.
Pointing the triangle at Qe. The point is at Qopt, where the two social curves meet.
Calling every polluting good a demerit good. Demerit goods carry external costs in consumption.
Assuming the market price is too low, therefore wrong. The exam wants you to argue about quantity and resources first.
Up next: Positive Externalities and Merit Goods — the same two diagrams turned upside down, where society ends up with too little of something good.
Want this explained one-to-one?
Book a free session with an experienced IB Economics tutor and get your trickiest topics made simple.
