Externalities: Negative Externalities

A negative externality exists when the production or consumption of a good imposes costs on third parties who are not involved in the original transaction and who receive no compensation for those costs. These external costs mean that the market price of the good is too low and the quantity produced or consumed is too high relative to the social optimum. Arthur Cecil Pigou (1920), in The Economics of Welfare, was the first to propose that the divergence between private and social costs constitutes a fundamental market failure requiring corrective action.

Key Definition: A negative externality is a spillover cost imposed on third parties as a result of production or consumption, for which no compensation is paid. It causes the social cost to exceed the private cost.

---

Private Costs, External Costs, and Social Costs

To understand negative externalities, it is essential to distinguish three types of cost: