Negative Externalities and Inefficiency:

As externalities are not reflected in market prices, they can be a source of economic inefficiency. Private consumption or production activities may generate costs, which are not "internalized" and not paid for by consumers or producers. As a result costs are imposed on society, which in question tends to be over-extended.

This is shown in the following diagram. External costs leads to the problem of dealing with social "bads" such as pollution and   environmental damage. Let us take an example of a steel plant dumping waste in a river. The marginal private cost schedule is lower than the marginal social cost schedule by the amount of external cost due to water pollution. This is represented by the distance  between both private and social cost supply curves. It is also assumed that there are no external benefits, which means social benefit = individual benefit.

In the fig:

C_s= Social Cost

C_p=Private cost

Q_s=Quantity Supplied if Social Cost is taken into account

P_p=Price if only Private Cost is taken into account

Q_p=Quantity Supplied if only Private Cost is taken into account

P_s=Price of Social Cost

E_s= Ideal equilibrium reflecting social cost

E_p= Actual equilibrium in private market (taking account of only private cost)

DD=Marginal benefit (given by demand curve)

When external cost is considered, then production should be increased only as long as marginal social benefit (MSB) exceeds marginal social cost (MSC). If the private cost of producing steel is considered individually then the equilibrium will be at P_p and Q_p, instead of the more efficient price Ps and quantity Q_s. It will result in inefficiency of a free market since the production of quantity Q_p indicates that marginal social benefit (E_p Q_p ) is less than the marginal societal cost (FQ_p). Therefore the society as a whole will be better off if the production of goods between Q_s and Q_p is stopped. The problem still persists as the people continue buying and consuming steel.

Thus, negative externalities encourage too many firms to remain in the industry as perfectly competitive firms produce according to market incentives.