Negative Externalities

When the product and/or consumption of a good or service exerts a negative effect on a third party outside the market

What are Negative Externalities?

Negative externalities occur when the product and/or consumption of a good or service exerts a negative effect on a third party outside the market. An ordinary transaction involves two parties, i.e., consumer and the producer, who are referred to as the first and second parties in the transaction. Any other party that is not related to the transaction is referred to as a third party.


Negative Externalities


Negative externalities are common where there are no property rights over assets and resources. This means that consumers can abuse them without worrying about court cases since there is nobody to file a lawsuit against them.

For example, oceans are a public utility, and nobody holds private rights over them. This means that ships and boats can pollute the sea since there are no property rights in the deep seas. The pollution affects other ocean users, such as fishermen who depend on the ocean water for their livelihood.


Negative Production Externalities

Negative production externalities occur when the production process results in a harmful effect on unrelated third parties. For example, manufacturing plants cause noise and atmospheric pollution during the manufacturing process.

Some examples of negative production externalities include:


1. Air pollution

Air pollution may be caused by factories, which release harmful gases to the atmosphere. Some of the gases include carbon monoxide and carbon dioxide. The destructive gases cause damage to crops, buildings, and human health. High concentration of greenhouse gases in the atmosphere affect the global climate and brings about extreme heat waves, rising sea levels, intense hurricanes, graded air quality, and droughts. The release of toxic gases into the atmosphere adversely affects vulnerable populations such as children, the elderly, and patients suffering from asthma and heart diseases.


2. Water pollution

When industrial wastes are released to water sources, it makes the water harmful to humans, animals, and plants that depend on it. Factory wastes often contain a mixture of various chemicals that cause death to aquatic animals living in the water, and it denies fishermen a source of income.

The contaminated water also affects plants that rely on clean water to survive. On the side of humans, drinking water that is contaminated with industrial wastes poses a threat to human life and can cause life-threatening diseases and even death.


3. Farm animal production

Raising farm animals may also result in a harmful effect on third parties who are outside the farm. For example, the overuse of antibiotics creates a large pool of antibiotic-resistant bacteria that spreads to other areas outside the farm and causes diseases to other animals. Also, the concentrated animal wastes cause contamination of rivers and streams and render the water unsafe for human use and consumption.


Negative Consumption Externalities

Negative consumption externalities arise during consumption and result in a situation where the social benefit of consuming the good or service is less than the private benefit. Private benefits refer to the costs incurred by the producer or the consumer involved in a transaction. For example, when a person consumes alcohol and becomes drunk, he/she causes social disorder, disturbing the peace of non-drinkers.

Some examples of negative consumption externalities include:


1. Passive smoking

Passive smoking refers to the inhalation of smoke by another person other than the active smoker. It occurs when tobacco and cigarette fumes permeate the environment and cause its inhalation by people within that environment. Inhaling other people’s smoke, also known as second-hand smoke, can cause diseases to the overall population.

Some of the smoking-related health complications include stroke, lung cancer, heart disease, and chronic obstructive pulmonary disease. High-risk populations such as children and the elderly are at a higher risk of respiratory infections such as asthma and bacterial meningitis.


2. Traffic congestion

When too many drivers use a road, they cause it to become congested, which means they incur longer driving times and frustrations to themselves and to other motorists as well. This forces other motorists to incur congestion costs for driving (such as longer longer driving times) on the road as well. A higher number of motorists driving in congested traffic also increases the likelihood of accidents involving other motorists and pedestrians.


3. Noise pollution

Noise pollution caused by loud music from a casino or nightclub may also affect third parties who are not part of the revelers dancing to the music. Loud music may be mentally and psychologically disruptive, especially to children who are yet to adapt to the surrounding environment. On the part of adults, noise pollution may cause sleep deprivation and affect their productivity at their workstations.


Remedies for Negative Externalities

One of the solutions to negative externalities is to impose taxes to change people’s behavior. The taxes can be imposed to reduce the harmful effects of certain externalities such as air pollution, smoking, and drinking alcohol. The tax equals the cost of the externality, and it is imposed with the goal of discouraging activities that cause such harmful effects.

Also, since most negative externalities result from the lack of property risks, governments can introduce property rights that will help internalize the costs and benefits. Putting property rights in place will create fear among would-be offenders since they will be wary of possible legal action against them.


More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Environmental Liability
  • Greenwashing
  • Network Effect
  • Pigouvian Tax

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