Externalities in production
These are costs or benefits associated with the production of goods and services that are passed onto third parties or spillover to affect others. Externalities in production result in social costs or social benefits faced by society more generally.
Negative externalities in production
These are costs incurred in the production of a good or service that are passed onto third parties or society more generally. Negative externalities (such as global warming) will result in an over-allocation of resources to the production of the relevant good or service. In simple terms, this means that too much of the product is being produced because producers do not incur all of the costs of its production. This results in a lower price compared to the situation it would face if its were required to incur the total (private and social) costs and therefore production of the product will be higher than the socially optimal level.
For example, a factory producing steel that allows its waste to flow down an adjacent river is an example of a negative externality in production. When a producer manufactures a product, it will typically only take into account the private costs associated with its production. It will generally not incorporate the costs that are passed onto others in the form of polluted air and rivers (social costs). If it did take into account these 'social costs' then it would charge a higher price (social price) and the consumption and production of the product would fall to a 'socially optimal level of output'.
Accordingly, governments force producers to take into account the social costs (internalise the externalities) via sanctions, such as fines for dumping waste or polluting public property. Increasingly, big businesses are internalising the externalities of their own accord via an emphasis on corporate social responsibility, appreciating that public exposure could ultimately result in loss of market share and profits.
Positive externalities in production
These are benefits resulting from the production of a good or service that are passed onto third parties or society more generally. Positive externalities (such as the benefits to other businesses and society when a firm produces training services for its staff) will result in an under-allocation of resources to the production of the relevant good or service. In simple terms, this means that not enough of the product is being produced because producers cannot capture all of the benefits stemming from its production. This results in a lower demand compared to the situation it would face if its were able to enjoy all of the total (private and social) benefits of production, which results in production occurring at less than the socially optimal level.
For example, a business that invests in research and development (R&D) or training of its employees is seeking to derive benefits (i.e. profit) from their production. However, these activities will tend to confer benefits to third parties or society more generally, such as when trained employees move to a new employer or when the R&D leads to new technological inventions or breakthroughs that, when taken up by multiple producers, improves the welfare of society more generally. Government intervention is required to internalise the positive externality in production by subsidising the production of things like R&D and training expenditure.