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Market Failure: Negative Externalities in Production

Updated: Nov 14, 2018

Theme 3: Market Failure and Governmental Intervention

Topic: Negative Externalities in Production

Relevance: H1 and H2 Economics


One of the major themes in microeconomics is the understanding of market failures and the need for government to intervene in order to correct those markets that failed. While market failures can occur in free markets and markets already with governmental intervention, the study of market failures usually starts with how the free market fails to allocate resources efficiently. Simplistically, market failure occurs when the market does not provide the right mix of goods or the optimal amount of a particular good or service. As a result, the market is not allocating resources efficiently and society’s welfare is not maximised. Allocative Efficiency is achieved when it is impossible to make anyone better off without making someone else worse off by changing the allocation of resources. Some of the important causes of market failures are:

  • Public goods (click here)

  • Positive externalities in consumption (click here)

  • Negative externalities in production (continue reading)

The case of Negative Externalities in Production and Market Failure:

In the pursuit of self-interest, producers and consumers consider only their private costs and benefits. They would only take into account their marginal private benefits (MPB) and marginal private cost (MPC) but they do not take into account third party, external costs or benefits in the making their decisions. Therefore, free market will produce and consume at the output where MPB=MPC at 0Qp in Figure 2 where private consumer’s welfare are maximised.

Figure 2: Negative Externalities in Production

However, due to the existence of negative externalities in production, there will be Marginal External Cost (MEC) or external cost incurred by the 3rd parties. 3rd parties are those not directly involved in the production and consumption of the good.

Negative externalities in consumption would result in Marginal Social Cost (MSC) to be higher than Marginal Private Cost (MPC) at every output.

Assuming, no positive externalities and external benefits, the Marginal Social benefits (MSB) is the same as Marginal Private benefits (MPB)

Allocative efficiency or the socially optimum level of output occurs where MSB = MSC at 0QS. It is at this level of output that resources are efficiently allocated to the production and consumption of the good and society’s welfare is maximised.

As the socially optimum level of output (0QS) is higher than free market level (0QP), there will be a net welfare loss to society or deadweight loss of the shaded area in Figure 2.

Therefore, due to the existence of negative externalities generated during production, the market fails as there is over allocation of resources or over production consumption of goods.

Related Articles:

Public goods (click here)

Positive externalities in consumption (click here)

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