AQA Specification focus:
‘Why negative externalities are likely to result in over-production and that positive externalities are likely to result in under-production.’
The interaction of private and social costs and benefits explains why negative externalities cause excessive production while positive externalities lead to insufficient provision in markets.
Understanding Over-Production and Under-Production
Markets allocate resources based on private costs and private benefits, but externalities create divergences from social costs and social benefits. This results in either over-production or under-production of goods.
Externality: A cost or benefit that affects third parties who are not directly involved in a market transaction.
When markets ignore these external impacts, they fail to achieve a socially optimal level of output, causing a misallocation of resources.
Negative Externalities and Over-Production
Negative externalities occur when the social cost of production or consumption is greater than the private cost faced by the producer or consumer.
Negative Externality: A harmful spillover effect of an economic activity on third parties, not reflected in the market price.
Why Over-Production Occurs
Producers base decisions on marginal private cost (MPC), ignoring marginal external cost (MEC). As a result, the marginal social cost (MSC) exceeds MPC, yet market equilibrium output remains higher than the socially efficient output.
Key points:
Market output is determined where demand (marginal private benefit, MPB) equals MPC.
True efficiency requires output where MPB = MSC.
Excess output leads to welfare loss.
Examples:
Industrial pollution (factories emitting CO₂).
Road congestion (private drivers ignore delays imposed on others).
Noise pollution (airports disturbing nearby communities).
The result is over-production, as firms and consumers fail to internalise the external costs.
With a negative production externality, MSC > MPC at each output; the competitive market equates MPB and MPC at Q_market, creating over-production relative to the socially efficient Q_social where MSB = MSC.
Negative production externality: MSC lies above MPC, so the unregulated market produces Q_market > Q_social. The shaded triangle indicates deadweight loss from over-production. Source
Positive Externalities and Under-Production
Positive externalities arise when the social benefit of consumption or production exceeds the private benefit, meaning individuals undervalue the good relative to its true social value.
Positive Externality: A beneficial spillover effect of an economic activity on third parties, not reflected in the market price.
Why Under-Production Occurs
Consumers and producers consider only marginal private benefit (MPB), neglecting marginal external benefit (MEB). The marginal social benefit (MSB) therefore exceeds MPB, but market equilibrium output falls short of the socially desirable output.
Key points:
Market outcome occurs where MPB = MPC.
True efficiency requires output where MSB = MPC.
The shortfall leads to under-provision and welfare loss.
Examples:
Vaccinations (individuals undervalue wider public health benefits).
Education (students focus on personal gains, not social benefits like productivity).
Public transport (individual use benefits society by reducing congestion).
The result is under-production, as markets fail to capture the full social value.
With a positive consumption externality, MSB > MPB; left to itself, the market produces at Q_market where MPB = MPC, causing under-production relative to Q_social where MSB = MSC.
Positive consumption externality: MSB exceeds MPB, so the market delivers Q_market < Q_social. The diagram uses a vaccination market to illustrate under-production. It also shows a subsidy as a correction, which is extra detail beyond the subsubtopic. Source
Diagrammatic Representation
While diagrams are not drawn here, students should recognise that:
For negative externalities, MSC > MPC. The gap reflects MEC.
For positive externalities, MSB > MPB. The gap reflects MEB.
The difference between market equilibrium and socially optimal output creates a deadweight welfare loss, shown as shaded triangles in standard diagrams.
Welfare Implications
The outcomes of over-production and under-production directly link to allocative inefficiency.
With Negative Externalities (Over-Production)
Society bears costs beyond private decision-making.
Over-production causes environmental degradation, congestion, and health impacts.
Government intervention (e.g., taxes, regulation) may be required.
With Positive Externalities (Under-Production)
Society misses out on additional benefits.
Under-production reduces economic growth and welfare.
Intervention (e.g., subsidies, public provision) can help bridge the gap.
Linking to the “What, How, For Whom” Questions
The imbalance created by externalities means that the market mechanism fails to answer:
What goods should be produced? (Too many “bads”, too few “goods”).
How should they be produced? (Ignoring true social costs).
For whom should they be produced? (Welfare not maximised).
Policy Context
Although this subsubtopic focuses on the causes of misallocation, understanding the policy context helps students see implications:
Corrective taxes reduce over-production of negative externalities.
Subsidies encourage greater consumption of positive externalities.
Regulation and property rights can also shift market behaviour closer to social optimum.
Key Takeaways
Negative externalities → over-production due to ignored external costs.
Positive externalities → under-production due to ignored external benefits.
Both lead to allocative inefficiency and require awareness for evaluation in AQA A-Level Economics.
FAQ
Deadweight welfare loss represents the lost economic welfare that occurs when markets fail to achieve the socially optimal level of output.
In the case of over-production (negative externalities), the cost to society exceeds the benefit of the additional units produced. With under-production (positive externalities), society misses out on potential benefits that outweigh the costs.
This lost welfare is usually shown as a triangle on standard externality diagrams, lying between the market equilibrium and the socially efficient output.
Consumers focus mainly on private benefits, such as personal health improvements from education or vaccinations. They often ignore the wider social benefits, like productivity gains or herd immunity.
Imperfect information also plays a role, as individuals may underestimate long-term advantages or fail to consider collective outcomes. This undervaluation discourages adequate demand, leading to under-consumption and under-production.
Externalities often involve delayed effects. Negative externalities like pollution may not reveal their full costs until years later, so production continues unchecked in the short run.
Positive externalities, such as investment in education, generate long-term benefits that individuals may discount. Because of these time lags, markets systematically misjudge the true value of production and consumption.
Not necessarily. For some goods, the external effects may be minimal or offset by other factors. For example:
A small café generating limited noise may not significantly harm third parties.
Certain cultural activities may create small positive spillovers, but not enough to justify government intervention.
It is the magnitude of divergence between private and social costs/benefits that determines whether misallocation becomes significant.
Elasticity influences how strongly output responds to externalities.
With negative externalities, inelastic demand means that reducing harmful consumption is more difficult, potentially leading to larger welfare losses.
With positive externalities, elastic demand makes subsidies or incentives more effective, as consumers are more responsive to price changes.
Thus, elasticity affects both the severity of misallocation and the effectiveness of policy remedies.
Practice Questions
Explain why negative externalities are likely to result in over-production in a market economy. (2 marks)
1 mark for identifying that producers base decisions on private costs only.
1 mark for explaining that this leads to output above the socially optimal level because social costs exceed private costs.
Using economic theory, explain why positive externalities in consumption can lead to under-production of goods such as education or vaccinations. (6 marks)
1 mark for identifying the existence of positive externalities (benefits to third parties).
1 mark for defining or describing marginal private benefit (MPB) and marginal social benefit (MSB).
1 mark for stating that MSB > MPB in cases of positive externalities.
1 mark for explaining that the market equilibrium occurs where MPB = MPC, not accounting for the external benefit.
1 mark for stating that this results in Q_market < Q_social (under-production).
1 mark for providing a clear example, such as vaccinations improving public health or education increasing societal productivity.
