What are negative externalities?

A negative externality is defined as the cost suffered by a third party (not involved in the transaction) as a result of the transaction. The consumer and producer are the two main parties in the transaction, but a third party is negatively effected by it taking place. An example of this can be water pollution from the production of chemicals leaking into a lake and killing fish, this would affect fishing in a lake. The fishermen in the lake are the third party who are negatively affected.

Negative externalities represent a type of market failure, as the the free market has not accounted for the full cost of the good. This means that the price set by the free market is below the true cost of the good. The negative externality is often called the 'social cost' of a good, and it is not taken into account in the free market price of a good. The true cost of the good is the social cost + the private cost.

In order to correct this market failure, governments can impose a tax on the good to raise the price. This will increase the price, so it is equal to the true cost of the good being produced. The tax can then be used to compensate the negatively affected party so they are no longer making a welfare loss as a result of the transaction taking place. Looking at the above example, the tax money can be paid to the fisherman in order to make up for the lost income as a result of the water pollution.