Positive and Negative Externalities

What is an externality?

Most of the time, a market deal affects only the buyer and the seller. Both agree to the price, and both get something out of it. Sometimes, though, a deal also hits someone who had no say in it.

There are two kinds:

• A negative externality imposes a cost on third parties. Examples: factory smoke, traffic jams, loud music at 3 a.m.

• A positive externality gives a benefit to third parties. Examples: a flu shot (your classmates are less likely to catch the flu), a beautiful garden that raises nearby home values.

In the paper mill example, the third parties are the downstream fishing businesses. They did not buy the paper and did not sell it, yet they pay the price in lost income.

Negative externalities: marginal private cost vs. marginal social cost

Firms decide how much to produce by comparing what each extra unit earns with what it costs them. That cost is the marginal private cost (MPC). If a unit also harms third parties, society bears an extra cost the firm ignores.

On the graph (Quantity on the horizontal axis, Price ($) on the vertical axis), the MSC curve lies above the MPC curve. The demand curve shows consumers' benefit. Since nobody else benefits, it is also the marginal social benefit (MSB).

Read the graph like this:

• The market ignores third parties, so it finds equilibrium where demand meets MPC: quantity Qm.

• Society wants the quantity where benefit equals the full cost, where demand meets MSC: quantity Q\*.

• Because MSC is above MPC, $Q^* < Q_m$. The market overproduces.

• Between $Q^*$ and $Q_m$, each unit costs society more (MSC) than it is worth to buyers (demand). Those units create a deadweight loss (DWL): the triangle between MSC and demand over the units that should not be produced.

Positive externalities: marginal social benefit

Now flip the idea. When a purchase benefits third parties, the buyer only counts her own benefit. That is the marginal private benefit (MPB), which is the demand curve. Society's benefit is bigger.

The logic mirrors the negative case:

• The market equilibrium is where demand (MPB) meets supply: Qm.

• The social optimum is where MSB meets supply: Q\*.

• Now $Q^* > Q_m$: the market underproduces. Units between $Q_m$ and $Q^*$ are worth more to society (MSB) than they cost to make, but nobody makes them. That lost benefit is the DWL.

Examples: vaccines, education, rooftop solar panels, home gardens, research and development.

Fixing externalities

The goal of a policy is to make decision makers face the full social cost or benefit. Economists call this internalizing the externality. The main tools:

• Pigouvian tax (for a negative externality): a per-unit tax equal to the marginal external cost.

• Subsidy (for a positive externality): a per-unit payment equal to the marginal external benefit.

• Regulation: a rule, such as an emissions limit or a mileage cap.

• Tradable permits: the government sets a total amount of pollution and lets firms buy and sell the right to emit it.

• Private bargaining (the Coase idea): if the people involved can negotiate cheaply, they may solve it on their own. This works mostly with few parties.

How a corrective tax works

A per-unit tax $t$ on producers adds $t$ to every unit's marginal cost. On the graph, the supply curve (MPC) shifts up by $t$. If $t$ equals the external cost, the new supply curve is exactly the MSC curve, so the market lands at the social optimum.

This is why it is called a Pigouvian (corrective) tax: it is named after the economist Arthur Pigou, and it corrects a distortion rather than just raising money. Taxing something that is already efficient would create a DWL, but taxing a good with a negative externality removes one.

Subsidies work the same way in reverse. A per-unit subsidy equal to the marginal external benefit lowers the producers' (or buyers') cost, which shifts the curve until the market reaches $Q^*$.

Taxes versus rules

A flat rule, like "every driver may drive the same number of miles," is blunt. It ignores how much each person values the activity. A tax lets people decide: those who value the activity most keep doing it and pay the cost, while those who value it least cut back first. The same total reduction happens at lower cost to society. This is why many economists prefer taxes or tradable permits. Rules can still be useful when the harm is severe or hard to measure, or when a tax would be hard to collect.

Summary

Back to the start: the mill's paper price covered only its private costs. Add the fishermen's lost income and the true social cost is higher, so the mill makes too much paper. A tax equal to that damage makes the price tell the truth.