Somebody makes a decision. Somebody else pays part of the bill. That is a negative externality, and it is the most examined idea in the whole of microeconomics. There are only two diagrams to learn here, they are mirror images of each other, and the only thing you have to get right is which curve splits away from which.
📘 What you need to know
An externality is a cost or benefit that falls on a third party who was not part of the transaction. Another name for it is a spillover effect.
A negative externality of production puts MSC above MPC. The good is over-provided.
A negative externality of consumption puts MSB below MPB. The good is over-consumed.
In both cases the free market quantity Qe is bigger than Qopt, and there is a welfare loss.
The welfare loss triangle always has its point at Qopt and its flat side at Qe. Its area is ½ × base × height.
Demerit goods are goods with external costs in consumption. They are usually harmful and often addictive.
Too many factors of production have been allocated to this good, so society could be better off making less of it.
What an externality actually is
Two people agree a deal. A driver buys petrol, a factory buys coal, a smoker buys cigarettes. They both weigh up their own costs and their own benefits, and if the deal is worth it to both of them, it happens. Nothing wrong so far.
The trouble starts when a third person, who never agreed to anything, ends up carrying part of the cost. The neighbour who breathes the fumes. The pedestrian who breathes the smoke. The taxpayer who funds the hospital ward. None of them were asked, none of them were paid, and the price in the market does not reflect them at all.
Ask yourself one question to spot an externality in an exam: who is affected who did not choose to be? If you cannot name that person, it is probably not an externality. Higher prices annoying customers is not an externality, because customers are inside the deal.
Externalities come in four versions, made by combining two questions. Is the spillover a cost or a benefit? And does it come from making the good or from using it? This page deals with the two costly versions.
Negative externalities of production
These are created while the good is being made. A steel plant releases fumes. A factory tips waste into a river. A shipping firm burns heavy fuel oil.
The firm pays for its workers, its machines and its raw materials, and those are its private costs. It does not pay for the dirty air or the poisoned river, so those external costs never appear on its accounts and never affect the price it charges. The cost to society is bigger than the cost to the firm, so MSC lies above MPC, and the vertical gap between them at any quantity is the external cost of one more unit.
The externality is on the producer side, so the market has two cost curves and only one benefit curve. The demand curve is labelled D = MPB = MSB, because the good does no harm to anyone when it is used.
How to explain this diagram in an answer
The free market settles at PeQe, where MPB = MPC. Firms are doing nothing unusual, they are just responding to the costs they can see.
Society would prefer Qopt, where MSB = MSC. That is a smaller quantity at a higher price.
So the market over-provides by Qe − Qopt. Too much land, labour and capital has been put into this industry.
Every unit between Qopt and Qe costs society more than it is worth to society. Adding up those losses gives the welfare loss triangle.
Because MSC is above MSB at the free market point, there is a case for government intervention to push output back down.
A rule that saves you every time: if the externality is on the producer side, you draw two supply curves. If it is on the consumer side, you draw two demand curves. Never four curves. Never two of each.
Negative externalities of consumption
These are created while the good is being used. Cigarettes are the standard example, but so are alcohol, fast food packaging and petrol cars.
Here the firm’s costs are honest enough. What is wrong is the benefit side. The buyer gets the enjoyment and counts it in full, but everyone else picks up the passive smoke, the litter, the noise and the strain on the health service. Because those costs cancel out part of the private benefit, the true benefit to society is smaller than the benefit to the buyer, so MSB lies below MPB.
Now the externality is on the consumer side, so there are two benefit curves and one cost curve, and the supply curve carries the label S = MPC = MSC.
How to explain this diagram in an answer
The market clears at PeQe, where MPB = MPC, because that is what buyers and sellers can see.
The socially best point is PoptQopt, where MSB = MSC, which is a smaller quantity at a lower price.
The market therefore over-consumes by Qe − Qopt.
The welfare loss triangle sits between MSB and MSC over that range, with its point at Qopt.
The bigger the external cost, the wider the gap between MPB and MSB, and the bigger the welfare loss.
Notice that Popt is above Pe in the production diagram but below Pe in the consumption diagram. Students lose easy marks by memorising “the optimum price is higher”. Work it out from your own diagram each time instead of remembering a rule.
Demerit goods
A demerit good is a good that creates external costs when it is consumed, and that consumers tend to buy more of than is good for them. Gambling, tobacco, alcohol, sugary drinks and hard drugs are the ones examiners expect.
Two features make them hard to deal with:
People undervalue the harm to themselves. The damage arrives years later, so it feels less real than the pleasure today.
They are often addictive, so demand is price inelastic. That matters enormously later, because it means a tax can raise the price a lot and cut the quantity only a little.
Economists usually treat demerit goods as a consumption problem rather than a production one. A coal power station creates plenty of external costs, but the smoke is a by-product, not the thing being sold, and electricity itself is useful. So that is a negative externality of production, not a demerit good.
Measuring the welfare loss
Welfare loss
Welfare loss = ½ × base × height
The base is the horizontal gap between the two quantities, Qe − Qopt. The height is the vertical gap between the two curves measured at Qe. Read both off the axes, do not guess, and keep the units the question gives you.
WORKED EXAMPLE
A market for diesel fuel is in equilibrium at 90,000 litres. The socially optimum quantity is 60,000 litres. At the free market quantity, MSC is $2.40 and MSB is $1.60. Calculate the welfare loss. [2]
Step 1: find the base of the trianglebase = 90,000 − 60,000 = 30,000 litresStep 2: find the height at Qeheight = $2.40 − $1.60 = $0.80Step 3: area of the trianglewelfare loss = ½ × 30,000 × 0.80Welfare loss = $12,000Always take the height at Qe, where the gap is widest. At Qopt the gap is zero, which is why the triangle comes to a point there.
WORKED EXAMPLE
In a market for cigarettes, MPB = 30 − Q, MSB = 22 − Q and MPC = MSC = 6 + Q, with Q in thousands of packs. Find Qe and Qopt, and calculate the welfare loss. [4]
Step 1: the free market uses the private curves30 − Q = 6 + Q, so 24 = 2Q and Qe = 12Step 2: society uses the social curves22 − Q = 6 + Q, so 16 = 2Q and Qopt = 8Qe is bigger, so cigarettes are over-consumed by 4 thousand packs.Step 3: height of the triangle at Qe = 12MSC = 6 + 12 = 18 and MSB = 22 − 12 = 10height = 18 − 10 = 8Step 4: area½ × 4 × 8 = 16Welfare loss = $16,000The external cost here is a flat $8 per pack, which is why MSB sits exactly 8 below MPB.
💡 Exam tip
Decide production or consumption before you pick up your pen. Made or used? That single choice decides which curve you split.
Shade the triangle and label it “welfare loss”. It is often worth a mark on its own, and it takes two seconds.
Name the third party. “External costs” is vague. “Residents living near the plant who suffer higher rates of asthma” is analysis.
Use the phrase “over-allocation of resources”. Examiners are listening for it.
Mention elasticity when you evaluate. Demerit goods with inelastic demand are stubborn, and that limits how well any price-based policy works.
Keep your units. If the axis is in thousands, say so in the final answer, or you will lose the accuracy mark.
⚠️ Common mix-up
Shifting the wrong curve. A negative externality of production does not move demand. Draw the second supply curve above the first.
Drawing MSC below MPC for a negative externality. Extra cost means the social curve is higher. If your diagram shows the opposite, you have drawn a positive externality by accident.
Measuring the height at Qopt. The gap is zero there, so you would get a welfare loss of nothing. Always measure at Qe.
Calling every harmful good a demerit good. Demerit goods are about consumption. Pollution from a factory is a production externality.
Saying the market failed because the price was too low. The price is a symptom. The failure is the quantity of resources going into the good.
Forgetting that a firm behaving legally can still cause market failure. Nobody has to be doing anything wrong for an externality to exist.
Up next: Positive Externalities and Merit Goods, which is the same two diagrams flipped over, with the market doing too little instead of too much.
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