What is Negative Externality?

Malcolm Tatum

A negative externality is a situation in which an individual or a business makes a decision but does not have to bear the full cost or outcome of that decision. Instead, at least part of the overall cost of that decision is passed on to society as a whole. When left unchecked, this type of economic phenomenon can lead to considerable social cost, and possibly undermine all or a portion of the marketplace.

Pollution is a negative externality.
Pollution is a negative externality.

One example of a negative externality has to do with the operation of a factory within a given community. As part of the costs of production, the business purchases utilities and raw materials to produce specific goods. As part of the production process, the factory may release pollutants into the air or possibly dump sewage into the local water system. Residents of the community are adversely affected by the operation of the plant, since the combination of air and water pollution is likely to create health issues that must be treated. As a whole, the community may have to engage in more aggressive efforts to purify the air and water, which leads to additional expenses to the local municipality.

In some cases, the nature of the negative externality has nothing to do with pollution, but with the production of excess goods. This has the effect of lowering the costs associated with producing each unit, which is a benefit to the company manufacturing those goods. Externally, this higher rate of production does have the potential to adversely affect the ability of competitors to sell enough of similar goods to remain in business. As a result, consumers ultimately have fewer choices in terms of brands to purchase, and the lower competition moves the marketplace closer to a monopoly situation. When this happens, consumers may eventually pay higher prices, simply because there is no other choice.

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Laws that help to minimize the possibility of some forms of negative externality are common today. This is particularly true when it comes to air and water pollution within a community. Firms that operate factories within the jurisdiction are typically inspected to make sure the facility is in compliance with local and national environmental regulations. Failure to comply can lead to hefty fines that have a negative impact on the benefits the company derives from the production process. In extreme cases, some governments are empowered to shut down the facilities until changes are made that bring the operation into full compliance.

Ideally, the companies themselves take steps to minimize the amount of negative externality that takes place as a result of the production process. This can be somewhat problematic for businesses with a need to alter production processes or invest in costly equipment to limit the extent of the externality. Since these activities are likely to decrease the company’s bottom line, it is not unusual for businesses to comply with governmental regulations that do limit negative externality, but do little above and beyond what is required by those regulations.

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