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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 independent of the transaction. An ordinary transaction involves two parties, i.e., a 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 commonly affect public resources where it is difficult to hold parties accountable such as in a case of environmental pollution. Producers or consumers may create a negative externality without worrying about lawsuits or fines.

For example, oceans are a public utility, and nobody holds private rights over them. Without regulations, ships and boats can pollute the sea which affects other ocean users, such as fishermen who depend on clean and productive 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.

The high concentration of greenhouse gases in the atmosphere affects 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 into public waterways it pollutes and makes it harmful to humans, animals, and the plants that depend on it. Factory wastes often contain toxic 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 cause harmful effects on third parties who reside near the farm. For example, the misuse of antibiotics can create a large pool of antibiotic-resistant bacteria that spreads outside the farm and causes diseases to other animals.

Also, accumulated animal wastes can leak and 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 cost of consuming the good or service is more than the private benefit. Private benefits refer to the positive factors rewarded to the producer or the consumer involved in a transaction. Social costs are negative factors impacting third parties. 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 exhaled by an active smoker. Inhaling other people’s smoke, also known as second-hand smoke, can cause diseases in the non-smoking 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, it causes delays and slower commuting times for all motorists. It also creates increased smog from higher idling times and increases the likelihood of accidents.

 

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. Also, noise pollution may cause sleep deprivation and affect the productivity of nearby residents and businesses.

 

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. An effective tax will equal 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

Financial Analyst Certification

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