External Cost. An external cost is an uncompensated cost imposed on 3rd parties not directly involved in a market transaction. Marginal social cost is greater than marginal social benefit.
At market equilibrium, agents act in their own self-interest and set at P* and Q*. The socially optimum equilibrium is at P’ and Q’. A negative externality occurs because MSC > MPC. External costs are imposed on third parties. The sum of these external costs is the welfare loss to society. A market does not exist for external costs, so the goods’ market price is too low and output is too high compared to the socially optimum level. Market failure occurs because the good is under-priced and over-consumed.
Negative externality examples:
- Air pollution from smoking or burning fossil fuels. This damages the climate, crops and people’s health.
- Water pollution by an upstream factory that discharges toxic waste into a river that travels downstream. Water, plants, sea life, animals and humans downstream are harmed.
- Alcohol and drugs intoxicate people and may cause them to injure or kill others.
- Noise pollution from a neighbour playing loud music at night when others are sleeping.
- Litter and destruction of buildings and the environment are bad to look at.