The Negative Externality of 
Production using Fertilizers 
 

Eddie Chen and Angela Wang 

May 29th, 2019 

 
 

Definitions 
In order to properly understand the idea of how the use of fertilizers in various industries can 
result in negative externalities of production, some basic terms should be defined in order to 
properly understand their use in the analysis of market failure.  

Market Failure​: An economic situation where the goods and services within a free market are 
ineffectively distributed, and the transaction between two stakeholders results in negative 
consequences for a third party, often society.  

Market failure is characterized when the following identity is not satisfied:  

Marginal Personal Benefit = Marginal Social Benefit = Marginal Social Cost = Marginal Personal Cost 

Externalities:​ The side effect or consequence of an economic transaction that affects a third party 
without this being reflected in the cost or benefit of the original transaction. 

Negative Externality of Production:​ The negative side effect or consequence on a third party as a 
result of the production of a good or service. 

Point of Allocative Efficiency​: The point at which resources within a market are optimally 
distributed. This is when marginal personal benefit equals marginal personal costs.​ ​Left up to its 
devices, the free market will always tend towards a point of allocative efficiency. 

Point of Social Efficiency: ​The point at which resources within a market are optimally distributed, 
taking into account all external costs and benefits to society. This occurs when marginal social 
benefit equals marginal social costs. 

Marginal Social Benefit:​ The benefit obtained by society when one more unit of the good/service 
is consumed or produced 

Marginal Personal Benefit:​ The benefit obtained by a firm or entity when one more unit of the 
good/service is consumed or produced 

Marginal Social Cost:​ The total cost society pays when one more unit of the good/service is 
produced. 

Marginal Personal Cost:​ The total cost a firm or entity pays when one more unit of the 
good/service is produced.   

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The Theory behind Negative Externalities of Production 

According to theory, when a firm produces a good, it incurs personal costs, which is the 
actual costs of producing the good itself. This can be any costs related to the factors of 
production that went into making the good itself (land required, labor costs, machinery costs or 
initial capital required.) This is all summed up and represented through the marginal personal 
costs, visualized by the MPC, or supply curve. At the same time, the firm knows that by producing 
that good or service, it may sell it in the market for compensation, which is summed up by 
marginal personal benefit, visualized by the MPB, or demand curve. Knowing that the market, left 
up to its own devices, will always tend towards the point of allocative efficiency, this would be 
determined by the intersection of the MPB and MPC curves, or where marginal personal benefit 
is equal to marginal personal cost. However, in a situation where the market has failed and a 
negative externality of production occurs, the production of that good or service results in a 
negative consequence for a third party not involved in the transaction, often society. Given that a 
negative consequence is present, it can be established that the costs for the society in producing 
this good is greater than the cost for the firm, resulting in the identity MSC > MPC, implying that 
there are external costs to society along with the costs of production. This results in the outcome 
where the marginal personal benefit equals marginal social benefit, but marginal social cost is 
greater than marginal personal cost.  

Since the firm is acting in its own self-interests, they will always produce goods and 
services at a quantity which is optimal for them, i.e the point of allocative efficiency. However, 
society’s best interests are when the marginal social benefit is equal to the marginal social costs, 
i.e at the point of social efficiency. Since the marginal social cost is much higher than the marginal 
personal cost; for the firm, producing towards the socially optimal point is unfavorable and would 
incur a loss, since marginal social cost is greater than marginal social benefit, which would 
contradict the firm’s best interests. Thus, the firm will not produce towards the socially optimal 
point but rather the point of allocative efficiency, in line with their own best interests rather than 
society’s. 

   

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The Use of Fertilizers resulting in Negative Externalities 

of Production 
To illustrate the idea of negative externalities of production with fertilizers, let’s use the 
example that Firm A decides to employ the use of fertilizers in their agricultural production of wheat, a 
staple crop produced in Canada. This would be in line with their best interests, as the firm’s best 
interest is maximizing personal benefit, which would be done by being able to  

increase quality and yield of their wheat through fertilizers. Given the market for wheat, as shown by 
the diagram on the left, 
where P0 and Q0 represent 
the price and quantities of 
the wheat produced at the 
point of allocative efficiency 
respectively , where MPB = 
MPC; and P* and Q* 
represent the price and 
quantities of wheat 
produced at the socially 
optimal point respectively, 
where MSC = MSB. Let’s say 
that the firm starts 
producing at the socially 
optimal point, at P* and Q*. 
Implementing marginal 
analysis, we look at the effect of producing one more unit on the market. As the market produces an 
additional increment of product, the price and quantity go from P* and Q* to PI and QI respectively, 
where PI and QI are the price and quantity of wheat in that increment. To produce that increment, the 
production shifts to the right in accordance with the arrow, to the intersection of PI and QI. At that 
intersection, MPB is greater than MPC. This means that by producing that extra increment, the firm 
receives more benefit than it does cost, making it favorable to produce. This results in the marginal 
benefit gained, represented by the green rectangle in the diagram. Looking at the next increment, the 
firm produces from QI to Q0. At any point between them, MPB is still greater than MPC. This again, 
means that it is favorable and in the firm’s best interests to produce that increment. The firm will only 
stop producing when MPB equals MPC, because for any point past this, MPC > MPB, meaning it would 
incur a loss and would be unfavorable for the firm to produce anymore. Thus, the firm would stop 

producing at the point where MPB = MPC, or the point of allocative efficiency.     

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Policy Solution: Tradable Fertilizer Emission Permits 

One potential solution is through a ‘cap-and-trade’ system; a system where firms are 
designated with tradable permits for their emissions through their process of production, and 
these limits designate the maximum level of pollution they can do over a certain period of time. 
For firms willing to invest in cleaner production methods, they are rewarded by having lower 
emission levels than their quota, and the remaining permits can be sold in the free market to 
other firms. One example of this system being implemented was to solve the issue of carbon 
dioxide emissions and how it impacts the rate of climate change.  

Applying this policy to fertilizer usage, we would first identify a situation where the 
production of a good or service using fertilizers directly resulted in a negative externality. The 
most prominent example of this is fertilizer runoff, where chemical fertilizers seep into streams 
and lakes which causes rapid growth of microalgae on the water’s surface. These algae consume 
the oxygen in the water, which result in the suffocation of fish and marine species. Once a 
situation where these negative externalities are present is identified, the local government would 
set a limit as to the amount of fertilizer that can be used. This would take into consideration 
previous levels of usage, as well as the extent of the damage. Next, local governments would 
designate tradable permits to firms within that area, which set a quota as to the maximum amount 
of fertilizers that can be used. This takes into consideration the size of the firm, as well as their 
impacts at a local and regional level. Once these permits are designated, firms that attempt to 
improve their methods of production; either by using less fertilizers in place of substitutes or 
finding other methods of reducing fertilizer runoff, are able to sell these tradable permits to other 
firms who have not yet improved upon their methods of production. Ultimately, this policy is 
beneficial due to the government implementing a solution to a negative externality that is 
market-based, which motivates firms to follow the system in pursuit of potential profit to be 
gained from trading permits.  

However, with every policy implemented, there are certain problems which require additional 
policies in order for the system to properly work. For example, one large problem with tradable 
permits is that it is difficult for the government to truly know how much a firm is polluting. A potential 
follow-up policy would be to send a government official to do routine emission checks at firms under 
the cap-and-trade system, which would ensure accuracy. Another criticism of the policy is that by 
implementing the system, firms must pay for their emissions, but this does not actually limit the level 
of emissions, which results in the same level of environmental damage. To counteract this, the 
government can introduce a follow-up policy which designates decreasing amounts of permits every 
year, which decreases the level of emissions that all firms are allowed to pollute, therefore resulting in 
an overall reduction.  

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Graphical Representation of Cap-and-Trade 

To illustrate the cap-and-trade system graphically, the following diagram below shows the 
implementation of a tradable permits policy onto the negative externality of production. Using the 
same market for wheat as the previous example, with the wheat in the agricultural industry being 
grown with fertilizers, 
we see the following 
effect. As the tradable 
permits policy is 
implemented, there is 
a limited supply of 
permits within the 
market, as the 
government intends 
to limit fertilizer 
emissions through a 
limited number of 
permits. This limits 
the quantity of wheat 
that can be grown 
with fertilizers every 
year, since these 
harvests are bound by the quotas set by the permits. This reduces quantity of wheat produced 
from Q0 to Q1, where the quota is set. As the quantity of wheat produces decreases yet demand 
remains constant, the price increases from P0 to P1 due to the limited supply. Ultimately, by 
implementing the tradable permits scheme in the market for wheat, the quotas set on fertilizer 
use limits the quantity of wheat that can be grown, which drives up the price. This incentivizes 
firms to find better and cleaner methods of growing wheat without the use of chemical fertilizers. 

In terms of the “price of pollution,” or the price of tradable permits in a market between 
firms, it was previously seen that governments can reduce the supply of permits to firms in an 
effort to reduce overall emission levels. By reducing this availability, the supply of permits curve 
shifts to the left, which increases the overall price of tradable permits in the free market. 
However, if the demand for pollution; that is, the desire for firms to pollute in order to produce 
goods, is increasing, this further drives up the price due to the higher demand and lower supply 
of available permits in the market. 

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Policy Solution: Tax on Polluting Firms 

Another potential policy that may contribute to a reduction in fertilizer emissions is to 
impose a tax on polluting firms based on the amount of emissions that they produce. For firms 
that heavily rely on chemical fertilizers, the tax implemented adds an additional cost to their 
production of goods, which translates to a shift of the marginal private cost curve up. For firms 
that are willing to utilise substitutes to chemical fertilizers or invest in better disposal methods as 
a part of their production process, this tax will have a less of an impact on their marginal private 
cost, which translates to a little or no shift in marginal private cost.  

Applying this policy to fertilizer usage, we would again first identify a situation where 
fertilizers have resulted in negative externalities. This could be either at a regional level, applied 
to a contained area where fertilizer damage is more extreme; or applied at a national level, 
aiming to minimize the emissions of fertilizers in all areas. After the tax is implemented, local 
governments would then be responsible for monitoring fertilizer emissions near firms that utilise 
them in their production. This could be done in different ways, such as looking at algae growth in 
waterways near polluting firms, or measuring oxygen content in those waterways and comparing 
them with past results to establish trends in the data. Finally, firms would be taxed based on the 
extent of their emissions and their trend in growth. Some factors to consider here would be the 
size of the firm, as larger firms would require more use of fertilizers, and the extent to which their 
production has affected the environment negatively.  

Again, there are problems with every policy, which require follow-up policies in order to 
reinforce their impact on reducing emissions. One problem to consider is that based on the 
region that the tax is implemented in, emissions may be greater or less in areas where there are a 
greater concentration of polluting firms. In regions where fertilizers are not as commonplace, 
there would be less emissions than a place where fertilizers are extremely common, but taxing 
the firms at the same rates would disincentivize firms to actually reduce their emissions, since 
certain firms are taxed at a much lower rate. To combat this, a follow-up policy could be 
introduced where firms situated in an area within a close vicinity of other polluting firms would be 
taxed at a much lower rate than standalone polluting firms. This way, standalone firms are held 
much more accountable for their fertilizer emissions, whilst a certain degree of leniency is given 
to firms situated in a region where there is more active production. 

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Graphical Representation of a Fertilizer Emissions Tax 

To illustrate the impact of a fertilizer emission tax graphically, we’ll take the same market 
for wheat in Canada, which again, uses fertilizers in its production. First, we assume that firms are 
normally producing wheat, at the point of allocative efficiency, where MPC = MPB. This starts us 
off at a normally 
produced 
quantity of 
wheat (Q0) at a 
certain price 
(P0). As the tax 
is introduced, 
firms must pay to 
use fertilizers as 
part of their 
production, 
which raises 
their average 
total costs per 
unit of wheat, as 
the price of the 
tax is equally 
distributed into 
the production cost for each unit of wheat. This shifts the supply curve left, as since revenue 
remains constant but costs have increased, the quantity that is able to be produced decreases. 
The amount of wheat that is produced is now at the intersection between MPB and MPC + Tax, 
and the quantity and price now have shifted from Q0 and P0 to Q1 and P1 respectively. By 
implementing the tax and shifting the supply curve left, the tax has internalized some of the 
external cost to society, and reduced the overall damage caused by polluting firms. This can be 
seen through the shrinking size of deadweight loss that is labelled on the graph, which accounts 
for the entire external cost to society. Before the tax is implemented, the deadweight loss is 
contained between the line Q0 extended to MSC and the point of social efficiency, or where 
MSB = MSB. After implementing the tax, the size of the deadweight loss has shrunk and is 
contained in the line Q1 extended to MSC. Since the size of the deadweight loss has decreased, 
it can be concluded that an emissions tax decreases the negative externality of production that is 
created through the use of fertilizers in the production of wheat.  

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