A negative externality occurs when an economic transaction imposes unintended costs on third parties who are not directly involved in the market transaction. These external costs are not captured in the market price.

Negative Externalities and Market Failure

Consider a chemical manufacturing plant that produces industrial chemicals for sale. The plant's private costs include raw materials, labor, equipment, and maintenance, which are reflected in the market price of the chemicals. However, during production, untreated wastewater containing toxic substances is discharged into a nearby river. The pollution affects downstream communities, harming aquatic ecosystems and increasing public health risks. The resulting costs to replace the lost benefits —borne by third-party residents and environmental systems—constitute external costs. Neither the plant nor its customers pay for the necessary compensation.

Social vs. Private Marginal Cost

In this scenario, the private marginal cost (PMC) of producing chemicals represents the cost incurred by the plant for each additional unit of output. However, the social marginal cost (SMC) is higher because it accounts for the added external marginal cost (EMC) associated with pollution. Adding the EMC to the PMC creates the social marginal cost curve. The key issue is that the chemical plant and its consumers do not bear the full burden on society arising from the environmental damage.

Socially Optimal Quantity and Deadweight Loss

The socially optimal quantity of output occurs where the SMC, which includes both private and external costs, intersects with the demand curve. However, the market equilibrium occurs at a lower quantity where the PMC, which only reflects the private benefits, intersects with the demand curve. The gap between the higher market quantity and the lower socially optimal quantity produced creates a deadweight loss to society. This area represents the loss of social welfare due to overproduction.

This inefficiency underscores the need for corrective measures to be imposed on the market, such as pollution taxes, regulations, or emissions permits. Such actions can align private incentives with social welfare to reduce the external harm being caused by the production process.