An externality is a side effect on people outside the deal. When it is a cost, the free market makes too much of the good: market failure.
Two kinds of negative externality
Of production
A factory's smoke harms the people who live nearby.
Of consumption
Smoking harms people nearby and raises health costs for everyone.
A demerit good
Cigarettes or alcohol: consumers underestimate the harm, so they consume too much.
The points to remember
- The market stops where MPC = MPB; society wants MSC = MSB.
- With a negative externality, the market makes too much: a welfare loss.
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Start with production. The external cost is the harm to people who are not buying or selling.
Our example (made-up numbers)
| Private cost | External cost | Social cost | |
|---|---|---|---|
| Each extra tonne | MPC | + €4 | MSC = MPC + €4 |
| Market output | 40 | Optimum: 20 |
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Remember it as: The firm pays MPC; society pays MSC. The gap is the external cost.
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Consumption works the same way, with the gap on the benefit side.
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The points to remember
- A negative consumption externality: MSB below MPB.
- Market output above the social optimum: over-consumption and a welfare loss.
Paper 2 asked this in May 2026, for 4 marks. Nearly every Paper 2 has an externality diagram like it.
Using an externalities diagram, explain how continued deforestation of a rainforest could lead to greater market failure.
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.
Animated graph
Watch the graph build step by step in study mode.
What the diagram must show
- Axes: costs and benefits up, Q along.
- D = MPB = MSB, S = MPC, and MSC above MPC.
- Qm (market) and Qopt (social optimum), the welfare loss, and MSC2 higher still.
How the 4 marks are given
| Marks | What your answer needs |
|---|---|
| 3–4 | A correct diagram and a correct explanation |
| 1–2 | A correct diagram or a correct explanation, not both |
| 3 at most | A diagram with a wrong or missing label |