Negative Externalities

A factory upstream pays for labor, materials, and machines, but not for the dirty water it sends downstream. Those costs land on the town, not the firm, so the firm's marginal private cost (MPC) is lower than the true marginal social cost (MSC) of production. The firm keeps producing as long as its own costs are covered, ignoring the extra burden it dumps on everyone else. That gap between MPC and MSC, equal to the external cost per unit, is the whole story of a negative externality.

On the graph, the firm produces where MPC crosses demand, at quantity Q_private. The efficient quantity Q_social sits where MSC crosses demand instead, and it's always smaller. Between those two quantities, the social cost of each unit exceeds what buyers are willing to pay for it, so every unit from Q_social to Q_private destroys value. That lost value is the deadweight loss triangle, bounded by the demand curve on top and the MSC curve on the bottom.

A corrective tax set equal to the external cost per unit shifts MPC up until it matches MSC, so the firm's own bottom line finally reflects the harm it causes. Output falls to Q_social and the deadweight loss closes. This is the same triangle logic as monopoly deadweight loss: price not equal to marginal social cost, whether from market power or from an uncounted cost, means units are produced that destroy more value than they create, or in monopoly's case, units that would create value go unproduced.