Supply side externalities

Externalities occur whenever a third party not directly involved in a transaction is affected by the transaction. These effects are external to market being studied, which is why they are called externalities. The most common example of a supply side --or firm-- externality is pollution. When a factory in California produces hot sauce for consumers in Florida, residents near the factory in California are affected by the dirty air or water even though they did not purchase the product. Because they were not involved in the transaction, their "cost" of dealing with the pollution may be ignored.

Looking at the graph, we can visualize this negative externality as the shift from MC1 (marginal cost to the firm) to SMC2 (social marginal cost). Because the cost to society is greater than the marginal cost to the firm, we need to shift the supply curve up to capture this. Once we incorporate the external cost, we see that the new equilibrium price is higher (because it includes ALL costs to society). The equilibrium quantity is also lower than the private solution, which demonstrates one way of dealing with the external cost (reducing production/consumption). This new equilibrium represents the societal optimum because social marginal benefit is now equal to social marginal cost. One way to achieve this new equilibrium is through the introduction of a tax. If the government can find out the value of the external cost, they can tax the firm this amount so that the external cost to society is now internalized in the firms decision making process (through higher costs).
Positive and negative supply externalities

However, it is also possible for there to be positive externalities associated with firms. Imagine a bee farm. Because of declining bee populations around the world, bee farms (or honey farms) provide a valuable service to nearby farms and orchards as well as the general environment. This can be visualized in the graph by looking at the SMC3 curve. We see that it is further to the right representing lower societal costs than the private costs incurred by the firm. This means that the welfare maximizing equilibrium occurs at a higher quantity and lower price than occurs in the private market. In order to achieve this point, the government may have to introduce subsidies to the farm to encourage higher production.

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