Question

Does the market overproduce or underproduce when third parties are exposed to negative externalities? Show your answer on a supply and demand graph

Answer 1

When third parties are exposed to negative externalities then social cost of production is greater than the private cost of production.

Following shows the market for a good with negative externality -

The above figure shows that marginal social cost curve (MSC) is on the left of the marginal private cost curve (MPC).

This indicates that MSC curve takes into account the negative externality while MPC does not take into account the negative externality.

The market quantity is Q (quantity corresponding to intersection of MPC and MPB curve) while socially optimal quantity is Q1 (quantity corresponding to intersection of MSC and MPB curve).

Market quantity, Q, is greater than the socially optimal quantity, Q1.

Thus, the market overproduce when third parties are exposed to negative externality.