Name the third party and the unpriced harm.
A negative externality is a cost imposed on people outside a production or consumption decision that is not reflected fully in the decision maker's private cost. Marginal social cost equals marginal private cost plus marginal external cost. With no external benefit, MSB = MPB. A competitive market ignoring the external cost trades beyond the social optimum because some units cost society more than they benefit it.
- Third party
- A negative externality is an unpriced cost imposed on people outside the decision. Neighbours losing sleep from deliveries bear a cost that the delivery firm does not fully pay.
- Private and external cost
- Marginal private cost (MPC) is the decision maker's cost of one more unit. Marginal external cost (MEC) falls on others. Add them to get marginal social cost: MSC = MPC + MEC.
- Benefit and quantity
- Marginal private benefit (MPB) is the buyer's benefit from one more unit. With no external benefit, MSB = MPB. Q means quantity; ignoring MEC can make the market produce more than the social optimum.
Build a complete externality explanation
Activity and people
Name production or consumption, identify the decision maker and the affected third party, and describe the actual harm. A supplier being paid less through ordinary competition is not automatically an external cost.
Unpriced effect
Explain why the harm is absent from private incentives. Being socially undesirable is a judgement, not a substitute for the mechanism.
Diagram
Put marginal dollars per unit vertically and quantity per period horizontally. Label MPC, MSC above it, MPB=MSB, Qmarket and the lower Qsocial. Shade only the welfare gap over the excessive units.
Production and consumption
Pollution from a factory and noise from a consumer can both create external costs. This chapter uses the official sufficient representation MSC above MPC; it does not require four separate diagram conventions.
Worked example: Noise from late deliveries
Each delivery gives benefits to the buyer and seller but creates unpriced sleep disruption for nearby residents. MPB = 20 - 0.1 Q, MPC = 4 + 0.1 Q, and MEC = $4 per delivery. Q is deliveries per day; marginal benefits and costs are dollars per delivery.
- Residents affected by the noise are the third parties. Delivery wages and fuel paid by the firm are private costs, not the externality.
- MSC = 8 + 0.1 Q, which is $4 above MPC. Assume no external benefit, so MSB = MPB.
- In this competitive model, private benefit equals private cost at 20 - 0.1Q = 4 + 0.1Q. Rearranging gives 16 = 0.2Q, so Q = 80. Including the external cost gives 20 - 0.1Q = 8 + 0.1Q, so 12 = 0.2Q and the social quantity is 60.
- Deliveries between 60 and 80 have MSC above MSB. Reducing those units raises net social benefit, holding the other assumptions fixed.
Watch out for this
Negative externalities mean MSC is below MPC.
External costs add to private costs: MSC = MPC + MEC, so positive MEC places MSC above MPC.
Check your understanding
Which is the clearest external cost of a factory's production?
- Wages paid to its employees.
- Materials bought from suppliers.
- Uncompensated pollution damage to nearby residents.