Negative externalities occur when an individual or business decision passes on some of the cost to society. This can lead to social costs and undermine the market. Laws exist to minimize negative externalities, such as pollution, but companies should also take steps to minimize them. Excess production can also negatively affect competitors and lead to a monopoly situation.
A negative externality is a situation in which an individual or business makes a decision but does not have to bear the full cost or outcome of that decision. Instead, at least part of the overall cost of that decision is passed on to society as a whole. If left unchecked, this type of economic phenomenon can lead to considerable social costs and can undermine all or part of the market.
An example of a negative externality has to do with the operation of a factory within a given community. As part of the cost of production, the firm purchases utilities and raw materials to produce specific goods. As part of the manufacturing process, the factory may release pollutants into the air or possibly discharge sewage into the local water system. Community residents are adversely affected by the operation of the plant, as the combination of air and water pollution can create health problems that need to be treated. Overall, the community may need to work more aggressively to purify their air and water, which incurs additional costs for the local municipality.
In some cases, the nature of the negative externality has nothing to do with pollution, but with the production of excess goods. This has the effect of reducing the costs associated with producing each unit, which is an advantage for the company that produces those goods. Externally, this higher production rate has the potential to negatively affect competitors’ ability to sell enough similar products to stay in business. As a result, consumers ultimately have fewer choices in terms of which brands to buy, and less competition brings the market closer to a monopoly situation. When this happens, consumers may eventually pay higher prices simply because there is no other choice.
Laws that help minimize the possibility of some form of negative externality are common today. This is especially true when it comes to air and water pollution within a community. Companies that operate factories within the jurisdiction are typically inspected to ensure that the facility complies with local and national environmental regulations. Failure to comply can lead to heavy fines that have a negative impact on the benefits the company derives from the manufacturing process. In extreme cases, some governments have the power to close facilities until changes are made that make the operation fully compliant.
Ideally, companies themselves take steps to minimize the amount of negative externality that occurs as a result of the manufacturing process. This can be quite problematic for companies that need to modify manufacturing processes or invest in expensive equipment to limit the extent of the externality. Because these activities are likely to reduce the company’s bottom line, it is not unusual for companies to comply with government regulations limiting the negative externality, yet do little beyond what those regulations require.
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