Externality of Production

Refers to all externalities created during the economic activities of production.

Author: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Reviewed By: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Last Updated:December 5, 2023

What Is Externality Of Production?

It refers to all externalities created during the economic activities of production. It makes an additional cost or benefit for an unrelated third party not involved in the production process.

Externalities refer to all unanticipated costs/benefits arising from economic activities, including consumption and production. The unrelated third party could be an individual, a firm, an organization, a community, or a society. 

The production contains all the processes needed to transform the inputs into outputs and to produce goods and services.

Production externalities involve all externalities arising from these processes. 

When the cost/benefit incurred by the third party is not included in the product's price, it is not considered the product's actual price, and this poses a severe problem that could lead to market failure.

Consider an example of a factory releasing harmful pollutants during production. It creates an unwanted cost for all citizens living in the vicinity due to related illnesses. 

Without regulations, the cost of the externality is borne by the citizens (in the form of healthcare expenses). However, in the case of tax imposition that concerns the producer, the price of goods increases, and consumers are forced to demand less. 

The externality now only affects the consumers and producers. A common cause of such externalities is the lack of well-defined property rights over common resources like air, water, or natural resources.

A factory owning the land has a right to produce goods but not to release harmful emissions in the air around the ground. 

Types of production externalities

An externality can be positive and negative depending on its effect on the third party. A positive externality creates a benefit (the Marginal External Benefit), whereas a negative one generates an additional cost (the Marginal External Cost).

A positive externality occurs when producing a good or service creates private benefits to the producer and society. For example, the research and development of technology in a field help advance all related fields.

Positive externalities may also cause market failure and need to be regulated because an externality alone causes imbalance when producers and consumers do not include external costs and benefits. 

In the absence of externalities, the equilibrium condition to determine the price of a good is

Consumers’ Benefits = Producers’ Cost.

that is,

P = MC


The equilibrium condition implies that the price of the goods paid by the consumer must be equal to the marginal cost incurred by the producer on the goods.

In the case of a negative externality, the external cost known as Marginal External Cost (MEC) must be included in the total cost.

The equilibrium condition for a negative externality is

Consumers’ Benefits = Producers’ Cost + Social Cost

P = MC + MEC



SMC = Social Marginal Cost of all factors in the society, i.e., Producers Cost + Social Cost 


When producers don’t account for the social cost, they assume their charges to be lower than the actual and tend to produce more than the equilibrium quantity.

Thus, in the case of negative externalities, producers tend to overproduce.

In the presence of a positive externality, the Marginal External Benefit (MEB) created in society must be included in the social benefits of production.

The equilibrium condition for a positive externality is,

Consumers’ Benefits + Social Benefit = Producers’ Cost 

P + MEB =MC 



SMB = Social Marginal Benefit of all factors in the society, i.e., Private Benefit to the consumer + Social Benefit 


When producers don’t account for the social benefit, they assume their costs to be higher and tend to produce less.

Thus, in the case of positive externalities, producers tend to underproduce.

Externality Of Production Examples

Some common examples of production activities that lead to positive externalities in society are:

  • Infrastructure Development- Infrastructure projects like the development of roads, public health facilities, and public transport in a community not only benefit the people availing such facilities but also the people in the vicinity. With an increase in the connectivity and development through roads and other facilities, the value of the real estate, level of economic activity, and the standard of living in an entire community increase.
  • Research and Development- Such instances are usually seen in the technology and scientific sectors, where the inventions and developments lead to further advancements in the field and other related areas. For example, the innovation of computer chips worldwide led to developments and further innovations related to computers and smartphones and continues to have significant positive effects.
  • Training and education- Employee training increases a worker's productivity, which benefits the employer. However, this training also creates additional benefits to any other firm the employee may migrate to. In the case of training beneficial to society like first-aid training or management training, additional personal benefits are also involved as the employee becomes a more responsible and essential part of society.
    Similarly, education imparted by institutions provides personal benefits to students, their future employers, dependent family members, and society. 
  • Pharmaceutical Production- In the case of a disease or contagious infection, the production of a drug or medicine, despite the high R&D costs, benefits the infected person and all others in society as it reduces the risk of infection.
  • Organic farming- The adoption of organic farming techniques by farmers has a positive effect on consumers and people in the surrounding areas from the harmful effects of pesticides.

Common negative externalities caused by production processes are:

  • Air pollution - It is commonly caused by factories involved in the burning of fossil fuels or factories releasing untreated pollutants through chimneys like coal-run rail engines harming all people living in proximity.
  • Water pollution- Oil tanker spills and drainage of chemicals by refineries or factories in water bodies affect fisheries and related businesses. It also inversely affects people depending on the water source for livelihood and consumption.
  • Noise pollution- The noise pollution caused by construction projects or airports hurts people living around the area. Proximity to airports and factories also reduces the price of real estate in the surrounding community.
  • Deforestation- The widespread cutting of trees for production in wood and paper-related industries harms all people and animals living in the vicinity and dependent on the forest as a source of livelihood. 

Managing and regulating externalities

The production externalities can be managed and regulated by minimizing costs incurred by the third party. This process is done in the following ways:

1. Taxes

Taxes are the most efficient form of managing externalities and reducing social costs. These taxes are imposed on the producer of goods. 

The producers tend to raise the price to cover the taxes, which decreases the demand for such goods to manage the problem of overproduction.

One such concept known as the Pigouvian tax was given by the economist Arthur C. Pigou. It states that the total magnitude of the tax must be equal to the externalities caused by the production.

That implies, 

Value of per unit Pigouvian tax = MEC of the externality

Price = Marginal cost (MC) + tax

This concept restores the equilibrium condition of

P = MC + MEC

2. Subsidies 

In the case of positive externalities, governments may provide subsidies to producers to overcome the problem of underproduction. Consequently, there will be a decreased production cost and an incentive for producers to produce more.

For example, producers unwilling to produce solar panels due to the high costs involved are given subsidies by governments, reducing their marginal cost.

3. Regulations

When the harmful effects of an externality are significant or affect a large share of the population, the government intervenes using legal jurisdiction. 

This may include the imposition of a complete ban on production activities in an area or the imposition of environmental or health regulations.

Researched and authored by Manya Bhardwaj  | LinkedIn

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