A negative externality exists when social costs exceed private benefits. The net effect of a negative externality results in social benefits and private costs.
The Correct Answer and Explanation is:
Correct Answers:
- A negative externality exists when social costs exceed private costs.
- The net effect of a negative externality results in social benefits less than private benefits.
Explanation
A negative externality occurs when the consumption or production of a good or service imposes a cost on third parties who are not directly involved in the economic transaction. These costs are not reflected in the market price, leading to overproduction or overconsumption from society’s perspective.
A classic example is pollution. Suppose a factory produces goods but emits pollution into the air as a byproduct. The private costs incurred by the factory include things like wages, raw materials, and machinery. However, the social costs also include the negative effects of pollution on the surrounding community—like health problems or environmental degradation—which are not borne by the factory but by society. Thus, social costs exceed private costs.
This gap causes inefficiency because the market produces more of the good than is socially optimal. If only private costs are considered, the market equilibrium quantity is higher than the efficient level. This overproduction results in what economists call a deadweight loss, or a net loss of social welfare.
Furthermore, the net effect of a negative externality is that social benefits are less than private benefits. While producers and consumers may receive benefits (such as profit and utility), the overall benefit to society is reduced due to the external damage inflicted on third parties. The true cost of the good or activity is underestimated, and as a result, too much of the harmful activity takes place.
Addressing negative externalities typically involves government intervention such as taxes (Pigouvian taxes), regulations, or the assignment of property rights (as in the Coase Theorem), which aim to internalize the external cost and bring the market outcome closer to the socially optimal level.
