This document discusses positive and negative externalities, which are the positive or negative consequences of economic activities on unrelated third parties. It provides examples of how externalities can arise from production or consumption. Positive externalities result in an undersupply of beneficial goods, while negative externalities lead to an oversupply of harmful goods, causing market failures. The document illustrates these concepts using supply and demand diagrams to compare social costs and benefits to individual costs and benefits.

1. Positive Externalities vs Negative
Externalities
Externalities are defined as the positive or negative consequences of economic activities on unrelated
third parties. Because the causers are not directly affected by the externalities, they will not take them
into account. As a result, the social cost (or benefit) of these activities is different from their individual
cost (or benefit), which results in a market failure.
There are different types of externalities. The definition above already suggests that they can be
either positive or negative. Additionally, there is another (and maybe less familiar) distinction
which should be made here: Both positive and negative externalities can arise on
the production or the consumption side. In the following paragraphs, we will look at the different
types of externalities in more detail.
Positive Externalities
Economic activities that have positive effects on unrelated third parties are considered positive
externalities. As we learned above, they may be presentin the form of production or consumption
externalities.
Positive Production Externalities
Positive production externalities are positive effects that originate during the production process
of a good or service. An example of this could be an orchard placed next to a beehive. In this
situation, both the farmer and the beekeeper benefit from each other, even though from an
economic perspective, neither of them has considered the other one’s needs in their decision-
making.
Positive production externality
This can be illustrated by comparing social cost and social benefit based on a supply and demand
diagram. In our example, individual demand (D) is equal to social benefit (SB) since there are no

2. externalities on the consumption side. However,social cost (SC) is lower than the individual supply (S)
because there is an external benefit (EB) that is not included in the individual supply curve. As a result,
the market equilibrium (E*) is different from the optimal market situation (O*) and there is an
undersupply of both orchards and beehives.
Positive consumption externalities
Positive consumption externalities are positive effects on third parties that originate from the
consumption of a good or service. A possible example could be your neighbor’s flower garden.
She probably cultivates the plants solely for her own pleasure, yet you can still enjoy the beauty
of the flowers whenever you walk by.
Positive consumption externality
Again, this can be illustrated by comparing social cost and social benefit. In this case,however,
the individual demand curve (D) lies below the social benefit curve (SB) because the external
benefit (the beauty of the flowers to others) is not included in the neighbor’s demand curve. The
social cost (SC) on the other hand is equal to the individual supply (S) because there are no
externalities on the production side. Like in the first illustration, the market equilibrium (E*) is
different from the optimal market situation (O*). As a result, there is an undersupply of flowers.
Unlike in the previous example, this time, the optimal price (p2) is higher than the equilibrium
price (p1).
Generally speaking, the overall benefit of positive externalities to society is higher than the one that is
taken into account by the actors in their decision-making. This results in an undersupply of beneficial
goods or services for society. To correct these market failures, it is important to know whether the
externality arises from the production or the consumption side since this affects the desired optimal
market equilibrium.
Negative externalities
Negative externalities are defined as economic activities that have negative effects on unrelated third
parties. They can be divided further into negative production and negative consumption externalities.

3. Negative production externalities
Negative production externalities are adverse effects that originate during the production process
of a good or service.The most common example of this kind of externality is the pollution caused
by firms during the production of their goods. Pollution affects the entire population; however as
long ascompanies are not held accountable for it, they have no incentive to reduce their economic
impact (because that would be more expensive).
Negative production externality
To illustrate this, we shall compare the social cost and social benefit again. Similar to the positive
externality example, individual demand (D) represents social benefit (SB). The social cost curve
(SC) in this case,however, is higher than the individual supply curve (S) because of the external
cost (EC) that is not included in the firm’s supply decision. As a result, the market equilibrium
(E*) is different from the optimal market situation (O*) and there is an oversupply of harmful
behavior. In this example, the optimal price of the good (p2) is higher than its actualmarket price
(p1).
Negative consumption externalities
Negative consumption externalities are negative effects that arise during the consumption of a
good or service. To give an example, we can revisit your neighbor. If she likes to play loud music
in the middle of the night, a negative externality on your part could be sleep deprivation. Once
again, she may not take this into account as the consequences do not directly affect her.

4. Negative consumption externality
In this case,the individual demand curve (D) lies above the social benefit curve (SB) because of the
external cost (your sleep deprivation) that is not included in the neighbor’s demand curve. The social
cost curve (SC) on the other hand is equal to individual supply (S) because there are no externalities on
the production side. Again, the market equilibrium (E*) is different from the optimal market situation
(O*), and as a result, there is an oversupply of loud music. In this example, the optimal price of the
good (p2) is lower than its actual market price (p1).
Without any regulatory influence, neither the firm nor your neighbor will take the negative effects
of their activities into account. They are not directly affected by the consequences and will thus
produce more than the socially efficient amount. This results in an excess supply of harmful
behavior.
In a Nutshell
Externalities are the positive or negative consequencesof economic activities on unrelated third parties.
They can arise on the production or the consumption side. In most cases,externalities result in a market
failure that can only be avoided by imposing some sort of regulation to internalize them.