Lesson preview · Spillovers
Negative externalities: why markets make too much
~7 min · Free to read
Farmers across the vast area that drains into the Mississippi River spread fertiliser on their crops. Rain washes some of it off the fields. Rivers carry it, with waste from towns, down to the Gulf of Mexico. There it feeds huge blooms of algae (tiny plant-like living things). When the algae die and rot, they use up the oxygen in the water, so fish and shrimp flee or die.
A low-oxygen “dead zone” forms there every summer. In 2025, scientists measured it at about 11,400 square kilometres. Its size swings with the weather. In 2026 a storm stirred oxygen back into the water just before the survey, and it measured only about 3,450 square kilometres.
The farms pay for their fertiliser, but not for the damage downstream. The people who fish in the Gulf bear that cost.
Key Term
Negative externality
A negative externality is a harmful spillover: a cost that making or using a good puts on third parties (people outside the deal). They didn’t agree to it and aren’t paid for it. The cost is real, but it isn’t in the price.
- In a production externality, making the good does the harm: factory smoke, fertiliser washing off a farm.
- In a consumption externality, using the good does the harm: loud music at 2 a.m., smoke from someone else’s cigarette.
Key Term
Private and social curves
Each point on the supply curve shows what one more unit costs the firm to make: its marginal private cost (marginal means “one more”). Add the harm to others, the external cost, and you get the marginal social cost: the cost of that unit to everyone. A unit that costs a factory 6 dollars, with 2 dollars of smoke damage, has a marginal social cost of 8 dollars.
Each point on the demand curve shows what one more unit is worth to its buyer: the marginal private benefit. Take away the harm the buyer does to others and you get the marginal social benefit: what that unit is worth to everyone. (Textbooks shorten these to MPC, MSC, MPB and MSB.)
- Harm from making the good: the social cost line sits above supply.
- Harm from using the good: the social benefit line sits below demand.
Either way, the gap between the lines is the external cost per unit.
Buyers and sellers count only their own costs and benefits, so the market ignores the harm. The socially best quantity, which economists call the social optimum, is the best amount for everyone once the harm is counted. It is where the social cost line meets demand, or the social benefit line meets supply.
In both cases, the market ignores 2 dollars of harm on every unit, so it makes 4 units when 3 would be best. This is a market failure: left alone, the market gets the quantity wrong. The triangle is the cost of that mistake, called a deadweight loss (a loss to society that nobody gains from).
Trap · Common Misconception
"Every harm goes on the supply side"
Loud music at 2 a.m. costs the neighbours sleep, but it doesn’t make the music cost more to supply. It makes the music worth less to society, so the harm goes on the benefit side. Neither curve shifts. Ask who does the harm: the maker (a social cost line above supply) or the user (a social benefit line below demand)?
Trap · Common Misconception
"The best amount of smoke is zero"
In the factory-smoke graph, the best quantity was 3 units, not 0, so the best amount of smoke is what those 3 units make. The first units are worth far more than their full cost, smoke included. Cut only the units that do more harm than good.
Second-hand smoke is a real consumption externality: the smoke that people near a smoker breathe in. According to the World Health Organization (2026), it kills more than 1.6 million people a year. The smoker weighs only their own enjoyment against the price. So the social benefit line for cigarettes sits below demand.
Check yourself · no marks
(a) A cement works covers nearby cars in dust. (b) Each extra car on a busy road slows down every other driver. Which is a production externality and which is a consumption externality? Where does the social line go in each case?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 5
Large livestock farms release a lot of methane, a gas that warms the planet. The harm falls on people everywhere, and the price of meat and milk doesn’t include it. What is this an example of?
Next
Like what you read?
Sign up free to save your progress, get spaced reviews tuned to you, and work through the whole course with interactive graphs and adaptive practice.