Externalities and the Gains from Trade Panel (a) illustrates a negative production externality, which means that the social marginal cost curve, SMC, lies above the private marginal cost (supply) curve S. With free trade, the price falls from P^A to P^W and Home supply falls from Q₀ to S₁. As a result, the social cost of the externality is reduced by area c, which measures a social gain that is additional to the private gains from trade, area b. Panel (b) illustrates a negative consumption externality, which means that the social marginal benefits, SMB, lie below the private marginal benefit (demand) curve D. The vertical distance between the SMB and D curve, times the quantity consumed, reflects the social cost of the externality. With free trade Home demand increases from Q₀ to D₁. As a result, the social cost of the externality increases by area d. That area is a social cost that offsets the private gains from trade, area b.