ChainWhat it assumes · how to break it
Start
A chemical factory discharges waste into a river, harming fishing businesses and households downstream who play no part in the factory's sales.
1
As a result, water quality downstream falls as the waste builds up in the river.
negative externality
negative externality
Assumes: The discharge is large enough to cause harm.
But: If the discharge is small relative to the river's flow, dilution may keep the damage low.
2
This means fishing businesses catch fewer fish and water companies must spend more treating water taken from the river.
external cost · third parties
external cost · third parties
Assumes: Third parties depend on the river for their income or supply.
But: Where few businesses use the river, the cost to third parties is limited.
3
Consequently, these third parties bear costs without compensation, because they are outside the transaction between the factory and its customers.
external cost · property rights
external cost · property rights
Best link to attack
Assumes: Those harmed cannot make the polluter pay.
Assumes: Those harmed cannot make the polluter pay.
But: Where rights over the river are clear and enforceable, those harmed can sue or bargain with the firm, which shifts the cost back on to the polluter.
4
In addition, nearby residents may suffer health problems and lose the use of the river for leisure, lowering their welfare.
external cost · amenity
external cost · amenity
Assumes: The pollution reaches people in harmful amounts.
But: Regulation of discharges by an environmental regulator may keep pollution below levels that harm health.
End
Third parties such as fishing businesses, water companies and local residents bear costs from the pollution that they did not choose and are not paid for.
Evaluation chain
- E1However, whether third parties end up bearing the cost depends on whether they have enforceable rights over the river.
- E2If ownership of the river is clear and only a few parties are affected, those harmed can take legal action or negotiate payment from the factory.
- E3As a result, the factory pays for the damage, so part of the external cost returns to the polluter.
- E4So the cost to third parties is smaller where rights are clear and parties few, but where many people are affected and harm is hard to trace, the cost of legal action is high and third parties still bear most of it.
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Questions this answers
- Explain how a negative production externality affects third parties.
- Analyse the costs that pollution from a factory imposes on people outside the market.
- Discuss whether those harmed by pollution should be compensated by the polluter.
Diagram
MPC (supply) and MSC above it, with MPB = MSB (demand): market output Q1 where MPC = MPB, social optimum Q* where MSC = MSB, so Q1 > Q*. The vertical gap between MSC and MPC is the external cost per unit borne by third parties.
Reverse and related
Positive production externality → third parties gain benefits they did not pay for, e.g. nearby farmers whose crops are pollinated by a beekeeper's bees.