Microeconomics · Complete guide
The four types of externalities
An externality is a side effect of producing or consuming something that lands on someone who didn't choose it and isn't paid for it. Split by whether it hurts or helps, and by whether it comes from production or consumption, there are exactly four types. Learn one diagram and one rule and you can draw all four.
Start here
The idea: costs and benefits that miss the price
A tannery upstream dumps effluent into a river. Its own costs are leather, labour and power, the marginal private cost (MPC). But the fishermen downstream lose their catch. That loss is real, it is caused by the tannery's output, and it appears in nobody's price. Add it on and you get the marginal social cost (MSC).
The two identities behind the whole topic
MEC: marginal external cost. MEB: marginal external benefit.
Key idea
Markets settle where private benefit meets private cost. Society is best off where social benefit meets social cost. When the two differ, the market produces the wrong quantity: that is a market failure, and the gap is measured by a deadweight loss triangle.
The map
The four types
Negative: harms others
Positive: helps others
From production
Negative production externality
A factory's smoke, stubble burning, a tannery's effluent in a river.
MSC = MPC + MEC, above supplyMarket over-producesFix: Pigouvian tax equal to the marginal external cost
Positive production externality
A beekeeper's bees pollinate the next-door orchard; R&D that other firms learn from.
MSC = MPC − MEB, below supplyMarket under-producesFix: Subsidy to producers equal to the marginal external benefit
From consumption
Negative consumption externality
Smoking in public, loud music at night, driving that adds to congestion.
MSB = MPB − MEC, below demandMarket over-consumesFix: Tax on consumption equal to the marginal external cost
Positive consumption externality
Vaccination (it protects others too), education, a well-kept front garden.
MSB = MPB + MEB, above demandMarket under-consumesFix: Subsidy to consumers equal to the marginal external benefit
The classic exam example
James Meade's apple farmer and beekeeper: the bees pollinate the orchard (a positive production externality from beekeeping) and the blossom feeds the bees (a positive production externality from the orchard). Effects running both ways between two parties are called reciprocal externalities.
Interactive
The externality diagram, all four ways
Pick a type. The dashed curve is the social one. The black dot is where the market ends up; the gold dot is where society would like it to be. The shaded triangle is the deadweight loss. Then apply the Pigouvian tax or subsidy and watch the market move to the efficient point.
Negative
Positive
In production
In consumption
MPB (demand)MPC (supply)MSC (social)Deadweight loss
Negative production externality
Producers ignore a cost they impose on others of ₹20 a unit, so left alone the market settles at Q = 40 while society is best off at Q = 30. The good is over-produced by 10 units, and the shaded triangle, ₹100, is the welfare lost.
The rule
Reading the diagrams: one rule
Which curve moves?
Production externalities change the cost side, so the supply curve gets a social twin (MSC). Consumption externalities change the benefit side, so the demand curve gets a social twin (MSB).
Which way?
Negative: society values it less (MSB below demand) or it costs society more (MSC above supply). Either way the efficient quantity is lower, so the market overproduces. Positive: the reverse, and the market underproduces.
| Type | Social curve | Market vs efficient | Deadweight loss triangle | Pigouvian fix |
|---|---|---|---|---|
| Negative production | MSC above MPC | Q market > Q* | Between MSC and demand, from Q* to Q market | Tax = MEC |
| Positive production | MSC below MPC | Q market < Q* | Between demand and MSC, from Q market to Q* | Subsidy = MEB |
| Negative consumption | MSB below MPB | Q market > Q* | Between supply and MSB, from Q* to Q market | Tax = MEC |
| Positive consumption | MSB above MPB | Q market < Q* | Between MSB and supply, from Q market to Q* | Subsidy = MEB |
Where the triangle points
The deadweight loss triangle always points at the efficient point, with its wide side at the market quantity. Its height there is the external cost or benefit per unit, and its area is ½ × MEC × (gap in quantity).
Policy
Fixing it: Pigou, regulation, permits
Pigouvian tax or subsidy
A. C. Pigou's answer: charge a tax equal to the marginal external cost at the efficient output (or pay a subsidy equal to the marginal external benefit). The private curve then matches the social one and the market finds Q* by itself. This is internalising the externality.
Regulation and standards
Cap emissions directly or mandate technology (filters, catalytic converters). Simple to enforce, but it ignores that some firms can cut pollution far more cheaply than others.
Tradable permits
Set the total quantity, then let firms trade the right to pollute (cap and trade). Firms that can cut cheaply sell permits, so the cap is met at the lowest total cost. The price is set by the market instead of the government.
Bargaining
The Coase theorem
Coase (1960)
If property rights are clearly defined and bargaining is costless, the affected parties will negotiate to the efficient outcome, and that outcome is the same whoever is given the rights.
Ronald Coase, Nobel Prize 1991.
Worked question · Coase in action
A factory's smoke costs a neighbouring laundry ₹300 a month. A filter that stops the smoke costs the factory ₹100 a month. What happens if the law gives the laundry the right to clean air? And if it gives the factory the right to pollute?
- Laundry has the right.The factory must stop the smoke or compensate ₹300. It fits the ₹100 filter.
- Factory has the right.The laundry pays the factory something between ₹100 and ₹300 to fit the filter. Both gain.
Answer
The filter is fitted either way: efficient. Only who pays differs, so the rights decide distribution, not efficiency.
The assumptions (a favourite exam question)
- Well-defined, enforceable property rights.
- Zero (or very low) transaction costs of bargaining.
- Few parties, so they can actually meet and negotiate.
- Full information about costs and benefits.
- No income or wealth effects on the valuations.
Pollution affecting millions of people breaks the second and third assumptions, which is why governments step in with taxes, standards and permits.
Numbers
Worked questions
Worked question · negative production externality
Demand: . Supply (MPC): . Each unit causes ₹20 of pollution damage. Find the market and efficient outputs, the deadweight loss and the Pigouvian tax.
- Market: MPB = MPC.
- Efficient: MPB = MSC = 40 + Q.
- Deadweight loss.
- Tax.A tax of ₹20 per unit shifts supply up to MSC, so the market produces 30.
Answer
Q market 40, Q* 30, deadweight loss ₹100, Pigouvian tax ₹20 per unit. This is the default setting of the lab above.
Practice
Exercises, with answers
A. Numbers
Problem 1 · negative production externality
Demand , supply (MPC) , marginal external cost ₹10 per unit.
Problem 2 · positive consumption externality
Private demand (MPB) , supply . Each unit consumed gives others a benefit of ₹20.
B. Name the type, and concepts
One attempt each.
1A beekeeper's bees pollinate a neighbour's apple orchard. This is a:
2Getting vaccinated also protects people around you. This is a:
3With a negative production externality, the competitive market output is:
4A Pigouvian tax is set equal to:
5The Coase theorem requires above all that:
Revise
One-page revision sheet
Definitions
MSC = MPC + MEC. MSB = MPB + MEB. Efficient where MSB = MSC; market where MPB = MPC.
Which curve
Production: supply gets a social twin (MSC). Consumption: demand gets a social twin (MSB).
Which way
Negative: market overproduces; tax. Positive: market underproduces; subsidy.
Deadweight loss
½ × external effect per unit × (market Q − efficient Q). The triangle points at the efficient point.
Fixes
Pigouvian tax/subsidy (= MEC/MEB at Q*), standards, tradable permits, Coase bargaining, merging the parties.
Coase
Clear rights + zero transaction costs ⇒ efficient outcome whoever holds the rights. Distribution differs.
Watch out for
The mistakes examiners are fishing for
- Shifting the wrong curve. A consumption externality moves the benefit (demand) side, not supply.
- Thinking positive externalities are “good for the market”. They still cause a failure: too little is produced.
- Setting the tax at the market quantity's damage. The Pigouvian tax equals the marginal external cost at the efficient output (the same number only when MEC is constant).
- Saying Coase needs the victim to hold the rights. Efficiency doesn't depend on who holds them, only that someone clearly does.
Try it on real questions
Fourteen past-paper questions on externalities
From UGC NET, IIT JAM, CUET-PG, GATE, JNU and the University of Hyderabad: classifying the four types, MSC and MPC, Pigouvian taxes, the Coase theorem and numeric deadweight-loss questions.
These are questions from the TestStop bank. A free account answers 10 a day, each with its worked solution; All-Access opens every set with no daily limit.
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