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IB DP Economics Study Notes

2.8.4 Negative Externalities of Production

Externalities arise when the actions of producers or consumers give rise to negative or positive side effects on others, which are not reflected in the prices of goods and services. Negative externalities of production occur when the production process causes a harmful effect on third parties. Let’s explore these in greater depth, focusing on pollution, over-allocation of resources, and the necessary corrective measures. For a foundational understanding, see the definition of externalities.


Pollution stands as a primary result of production processes. Without adequate control and measures, various forms of pollution can arise from diverse industries.

Air Pollution

  • Origins: Produced when factories emit harmful chemicals, smoke, or particulate matter into the atmosphere.
  • Effects: Contributes to respiratory illnesses, environmental harm such as acid rain, and adds to global warming through the greenhouse effect.
  • Examples: Combustion of fossil fuels in factories releases sulphur dioxide and nitrogen oxides, which can cause smog and respiratory problems.
An infographic illustrating the effects of air pollution

Image courtesy of unfccc

Water Pollution

  • Origins: Emerges when industrial waste products are introduced into water bodies without proper treatment.
  • Effects: Deteriorates aquatic life, disrupts ecosystems, and renders water unsafe for consumption and recreational activities.
  • Examples: Runoff from agricultural fields can contain pesticides and fertilisers, which eutrophicate water bodies leading to harmful algal blooms.

Soil Pollution

  • Origins: Happens due to the dumping of solid wastes, chemicals, or untreated sewage on land.
  • Effects: Alters soil structure, reduces fertility, affects terrestrial life, and presents risks to humans through the food chain.
  • Examples: Industries dealing with chemicals may sometimes dispose of them improperly, seeping harmful chemicals into the ground.

Noise Pollution

  • Origins: Caused by large industrial machinery, transportation facilities, or even regular construction processes.
  • Effects: Leads to health issues like hearing impairment, cardiovascular diseases, sleep disturbances, and even mental health problems.
  • Examples: Factories situated near residential areas can cause daily disturbances due to their loud operations.

Understanding the broader implications of such pollution on society and ecosystems is crucial. More on this can be found under externalities and welfare loss.

IB Economics Tutor Tip: Understanding negative externalities of production is crucial for analysing how businesses impact society and the environment, highlighting the importance of sustainable practices and regulatory measures for economic balance.

Over-allocation of Resources

The tendency of markets to allocate too many resources towards the production of certain goods can exacerbate negative externalities.

A graph of negative production externality

A graph illustrating overproduction due to negative production externality.

Image courtesy of thecuriouseconomist

Why it Happens?

  • Private Cost Focus: Enterprises mainly take into account their own private costs and benefits, overlooking societal costs.
  • Profit Maximisation: Motivated by profit margins, producers might increase production even if it means more environmental harm.
  • Regulatory Lapses: An absence of strict regulations allows businesses to exploit resources unchecked.


  • Resource Depletion: An increase in production might exhaust non-renewable resources at a rapid rate.
  • Unsustainability: The rate of usage might make certain resources unsustainable in the long run.
  • Societal Burden: Overall societal health and well-being can deteriorate due to over-allocation, manifesting as health issues, reduced quality of life, and potential resource scarcities.

This over-allocation often leads to government and market failures, highlighting the need for intervention.

Corrective Measures

To alleviate the challenges posed by negative externalities of production, interventions are pivotal. These can be governmental, societal, or market-driven.

Environmental Regulations

  • Emission Standards: Enforcing thresholds on pollutant emissions.
  • Mandated Eco-friendly Tech: Pushing industries to integrate cleaner production methods and technologies.


  • Pigouvian Taxes: Taxes levied on businesses generating negative externalities. Their aim is to make businesses internalise external costs. A carbon tax, for instance, charges firms based on their carbon emissions. More about the role of taxation in managing externalities.

Tradable Emission Permits

  • Functionality: This system allows businesses to buy or sell their right to emit a predetermined amount of pollutants.
  • Cap-and-trade: A system where the government sets an overall 'cap' on emissions. Firms that manage to reduce their emissions below their quotas can sell their extra allowances to those that exceed.

Public Awareness

  • Education: Making both producers and consumers aware of the harms of unchecked production and the merits of sustainable practices.
  • Effect: An informed consumer base can exert demand-side pressure on firms, compelling them to transition to eco-friendly production techniques.

Subsidies and Incentives

  • Green Tech Subsidies: Financial incentives for industries that invest in sustainable technologies.
  • R&D Grants: Providing grants for research and development in eco-friendly production processes.
  • Effect: These measures reduce the financial burden on businesses and make the shift to sustainable practices more economically appealing. Subsidies play a significant role, as discussed in subsidies and their effects.

Direct Control and Legislation

  • Direct Regulation: Governments can impose direct bans on certain harmful products or production methods.
  • Quotas: Limits on the production levels of certain goods can be implemented to prevent over-allocation.
  • Licensing: Ensuring factories comply with environmental standards before being granted the necessary licenses to operate.
IB Tutor Advice: When revising negative externalities, focus on real-world examples to illustrate each type of pollution and the effectiveness of different corrective measures in mitigating their impacts.

In Depth

Negative externalities of production, predominantly manifesting as pollution and the over-exploitation of resources, present a significant societal and environmental challenge. However, with a blend of regulatory, economic, and informative countermeasures, their impacts can be mitigated, fostering a balanced coexistence of industry, society, and the environment. It's also important to consider the negative externalities of consumption as both production and consumption externalities contribute to the broader picture of environmental impact.


Some firms might choose to take corrective measures voluntarily because of a combination of ethical considerations, consumer demand, and long-term profitability. Ethically-driven companies recognise their responsibility towards the environment and society and take steps accordingly. From a consumer standpoint, as awareness of environmental issues grows, there's increasing demand for sustainable and ethically-produced products. Meeting this demand can give firms a competitive advantage in the market. Furthermore, in the long run, sustainable practices can lead to cost savings for firms. For example, reducing waste or recycling can lower production costs. Additionally, being proactive can also mean that firms stay ahead of potential future regulations, avoiding future compliance costs.

Yes, an economy can indeed grow while curbing negative externalities of production. This approach is termed 'sustainable growth'. To achieve this, governments and businesses must invest in eco-friendly technologies, sustainable farming practices, and renewable energy sources. Regulations can be established to incentivise or compel businesses to adopt greener production methods. Additionally, by investing in research and development of sustainable practices, new industries and job opportunities can be created, driving economic growth. Essentially, it requires a shift from a purely profit-driven model to one that values sustainability and long-term societal welfare.

Certainly, while the primary aim of corrective measures is to address negative externalities, they can sometimes lead to unintended consequences. For instance, implementing a tax on pollutants might result in firms relocating their production to countries with laxer regulations, a phenomenon known as 'carbon leakage'. This doesn't reduce global emissions but merely shifts the location of the pollution. Another potential consequence is that while correcting one issue, a new problem might emerge. For example, biofuels were once championed as an eco-friendly alternative to fossil fuels. However, large-scale biofuel production led to deforestation and competition with food crops, causing other environmental and social issues.

Negative production externalities distort market efficiency because the external costs they produce aren't reflected in the market prices. In an efficient market, prices would account for all costs – both private and societal. However, when producers don't bear the external costs of production, such as pollution, they might produce more than the socially optimal level. This results in what economists call 'deadweight loss', which represents the inefficiency in the market. Essentially, resources are not being allocated in a way that maximises total societal welfare, causing the market to fail in delivering the most favourable outcomes for society.

The long-term implications of negative externalities of production on global sustainability are profound. Firstly, continued environmental degradation, primarily due to unchecked pollution, can lead to irreversible damage to ecosystems. This loss of biodiversity hinders the ecosystem's ability to regenerate and support life. Additionally, the over-allocation of resources, particularly non-renewable ones, speeds up the depletion of these resources, reducing their availability for future generations. As these resources become scarcer, it may lead to global conflicts and competition. Moreover, unchecked pollution can accelerate climate change, causing extreme weather events, sea-level rise, and endangering coastal regions and communities.

Practice Questions

Explain the impact of over-allocation of resources on society due to the negative externalities of production.

Over-allocation of resources primarily stems from producers focusing predominantly on private costs, rather than societal costs. When there's a disproportionate focus on profit maximisation without considering the societal repercussions, it can lead to resource depletion. As resources are overused, it heightens the risk of exhausting non-renewable resources, rendering them unsustainable in the long run. Moreover, the unchecked production processes often result in environmental degradation, such as pollution. This, in turn, affects the overall societal health and well-being, leading to health issues, reduced quality of life, and potential scarcities, further straining economic systems and public health infrastructure.

Evaluate the effectiveness of tradable emission permits as a corrective measure to address negative externalities of production.

Tradable emission permits offer an innovative approach to regulating pollution by providing economic incentives for businesses to reduce emissions. Under this system, firms that reduce their emissions below set quotas can sell their surplus allowances to firms that exceed. This creates a market-driven approach to environmental regulation, potentially making it more efficient. The cap-and-trade system, specifically, provides a clear overall 'cap' on emissions, ensuring a limit on environmental damage. However, the effectiveness largely depends on the strictness of the cap and the enforcement of the system. If caps are too lenient or enforcement is lax, it can undermine the system's purpose, allowing excessive pollution despite the permits in place.

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Written by: Dave
Cambridge University - BA Hons Economics

Dave is a Cambridge Economics graduate with over 8 years of tutoring expertise in Economics & Business Studies. He crafts resources for A-Level, IB, & GCSE and excels at enhancing students' understanding & confidence in these subjects.

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