Production Externality

Updated on April 4, 2024
Article byPrakhar Gajendrakar
Edited byPrakhar Gajendrakar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Production Externality?

Production externality occurs when manufacturing or production results in the creation or release of byproducts or side effects that impact the environment. These byproducts can be waste materials, such as discarded or new substances, or unwanted chemicals emitted into the air, water, or soil.

Production Externality

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When production externality is never the main objective of the product or services but indirectly covers it, the externality can be social, economic, health-related, or environmental. In economics, it is the gap between the actual production cost and the real cost to society. Generally, a business must reduce its negative externalities from its production process.

Key Takeaways

  • Production externality means the indirect product or waste that gets manufactured or released in society from the primary production process.
  • AC Pigou was the first to conceptualize the theory of externalities and argued for imposing taxes and introducing subsidies.
  • The nature of externality, whether positive or negative, is determined by its cause and impact on society. 
  • There is a difference between the externalities created by the production and consumption of a product, and they are not the same.

Production Externality Explained

Production externality is the indirect aspect of production that gets produced or created with the primary production process. It is mainly concerned with third-party benefit or cost, the production unit or business has no direct intention to produce it, but it’s a byproduct of its operations in the manufacturing process.

Arthur Cecil Pigou, an economist from England, who worked at the University of Cambridge, was the first to discuss this idea. He was famous for his work in welfare economics. In his book “The Economics of Welfare,” Pigou explained the concept of externalities, which are costs or benefits that affect other people but are not considered in the production process. This idea was based on Alfred Marshall’s concept.

AC Pigou also believed that if an activity has a negative externality, the person or entity performing it is engaged far more than needed. It is also a sign for the government to intervene in it. He also devised subsidies for such externalities, called the Pigouvian taxes and subsidies.

Any business producing a product or offering a service leaves a residual or waste material. This residual is commonly released into the environment through different channels. When released, it can either harm the environment or leave a positive impact on society. Of course, the production process can be neutral with no positive or negative externality, but it is a common scenario in industries and factory-related operations.

Every company tries to speculate and reduce its negative externalities. At the same time, the positive externalities are celebrated by businesses and society. In business economics, the cost or benefit society faces because of the goods externality is also accounted for when deriving a product’s value.

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There are primarily two types of production externalities –

  1. Positive production externality – It occurs when a production process creates or releases a positive aspect or element in the environment or society. For example, when sugar is produced in factories, a good amount of ethanol is produced, a fuel that can be used for several other purposes.
  2. Negative production externality – It refers to the adverse effects or waste generated by a production process that harms the surrounding area or society. For example, a tobacco factory not only creates an unhealthy environment, but the people working in the factory are in more in-person contact with it.


Let’s understand the topic through the example of both production externalities.

Example #1

For a positive production externality, Tyler, who is preparing for a central government job, likes to teach about the same syllabus and subjects to students from his locality who are not privileged and come from poor financial situations. He encourages them and gives them proper guidance on learning and cracking the same examination in the future.

Here, Tyler’s primary process is preparing and cracking the examination. Still, his teaching of needy students allows him to concentrate more on his preparation, which can be considered a third-party benefit to the students. This whole scenario is leaving a positive impact on society.

Example #2

Let’s understand the negative production externality. Suppose a nine-day music festival is held in the city center. It is a vibrant and enjoyable event for attendees, featuring talented artists, enticing food, and opportunities to explore. However, the festival also brings negative consequences to the adjacent suburban areas.

Families, elderly citizens, hospitals, and sensitive locations suffer from prolonged noise pollution for the entire duration of the festival. Additionally, the influx of tourists results in increased garbage, large crowds, and frequent traffic jams, burdening the residents with these challenges.

Production Externality vs Consumption Externality

  • Production externality occurs during producing or manufacturing of a good or service, while consumption externality arises when individuals consume or utilize a product.
  • A product can have a production externality and not a consumption externality. In contrast, a product can have a consumption externality but no production externalities. Also, a product can have both or in combination.
  • Businesses generally do not intend to produce externalities, aiming to optimize their production processes. But consumers are aware of the consumption externalities as they make choices and decisions regarding the products they consume and the associated impacts.

Frequently Asked Questions (FAQs)

1. What is the difference between negative consumption and production externality?

Negative consumption arrives when a consumer consumes a product and it emits terrible effects on the environment, a third party, or society. But production externalities can be positive because they create a good outcome or release a valuable byproduct from the production process.

2. Is pollution an externality in production?

Yes, pollution and, more specifically, air and water pollution are some of the most significant negative externalities of production. In addition, many products, goods, and chemicals generate substantial amounts of waste in the form of debris, gases, and harmful substances released into the environment as industrial waste.

3. What happens if there is a negative externality in production?

A negative externality harms society and the environment, even for the people involved in the manufacturing process, because they are the first and most close to production. When such a negative externality is released into the environment, it slowly starts to harm the atmosphere, gasses, and ecosystem we live in.

This article has been a guide to what is Production Externality. We explain its types (negative and positive) along with its examples & vs consumption externality. You may also find some useful articles here –

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