What is a primary effect of negative externalities on the economy?

Negative externalities occur when the production or consumption of a good or service imposes costs on third parties who are not directly involved in the transaction. This situation often leads to overproduction of goods that create these externalizing effects, as the price paid by consumers does not reflect the true social cost of that good or service.

For instance, consider a factory that pollutes a river while producing goods. The factory does not bear the full cost of the pollution; rather, the community bears the negative impact, such as health issues and environmental degradation. As a result, the market price does not account for these costs, leading to a quantity produced that exceeds the socially optimal level.

This misalignment between private costs and social costs is what causes market failure. Resources are not allocated efficiently because the negative consequences of production are not internalized by the producers or consumers. Instead, the market fails to regulate itself effectively, necessitating intervention or policy changes to correct the imbalance. Recognizing how negative externalities distort production helps illustrate why effective regulation and policies are essential to minimize market failures and enhance overall economic welfare.