Externality

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Last Updated:November 10, 2023

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What is an Externality?

It refers to an unanticipated cost or benefit arising from an economic activity that an unrelated third party experiences. It arises from the economic activities of production or consumption.

The unrelated third party could be an individual, firm, organization, community, or society in general.

An externality can be both positive and negative, depending on its effect. A positive externality creates a benefit to a third party. Conversely, negative externalities create an additional cost to be incurred by a third party.

Since the price of a good does not reflect the cost or benefit associated with it, it is not considered to be the actual price. Hence, they pose a serious problem that may lead to market failure.

Understanding Externalities

It arises when the production or consumption of a good creates an additional cost ( called the Marginal External Cost) or an additional benefit ( called the Marginal External Benefit).

These costs and benefits are incurred by an unrelated third party not involved in producing or consuming the good. For example, a factory releasing pollutants while producing a commodity creates a negative effect of pollution.

In the absence of legislation or government intervention, the cost of this pollution would have been borne by the residents (in the form of healthcare expenses) or the local governing body (as expenditure on clean air resources).

However, as the government imposed taxes on the pollution caused by the producers, the producers raised the price of the goods and passed the burden to the consumers.

The pollution cost now affects only the producers and consumers of the good.

A primary cause is the poorly defined property rights on resources like air, water, and public land. In the above example, property rights are defined on the producer's land, implying he is free to produce any good.

However, the air rights around the land remain ambiguous as it affects all. This restricts the producer as the production process involves contaminating a public resource.

Types of Externalities

Generally, there are two types of externalities:

1. Negative Externalities

Negative externalities occur when the social cost of economic activity is more than the private cost to the consumer or the producer. This is because social costs are incurred by other members of the society besides the consumer.

Most unanticipated effects of production are negative.

For example, a producer tends to shift to more efficient machinery to cut costs but, in the process, releases more pollutants into the air.

In this case, the cost of pollution to society exceeds the cost of machinery. As a result, the producer is now earning more returns than the cost. This creates a negative effect.

2. Positive Externalities

Positive externalities occur when an economic activity leads to both personal and social benefits. The social benefits exceed the private benefit.

For example, research and development benefit producers or researchers concerned with a particular field. However, it also helps in the technological advancements of all other related fields.

The invention of computer processor chips continues to have great positive effects in the field of technology in the modern world.

Positive effects may still lead to market failure and must be regulated. The presence of an externality alone causes disequilibrium in the market when the producers or the consumers do not include the external costs and benefits.

Positive effects of production and consumption

The positive effects of production and consumption are all production and consumption activities that benefit the society or the community and the producers and the consumers.

Examples of positive production effects include

Infrastructure Development: The development of infrastructure like roads and public transport in an area benefits people using such facilities and the community as a whole. With an increase in connectivity and development, the value of the real estate and the standard of living of the entire community increase.
Research and Development: These externalities usually arise in the technology sector as more inventions facilitate more advancements.
Training: employee training leads to increased productivity for a firm. It also leads to benefits for a future firm the employee may migrate to. In the case of First aid training and management training, it also leads to additional personal benefits for an employee and contributes to society.
Pharmaceutical Production: In the case of a disease or contagious infection, the production of a drug or medicine, despite the high R&D costs, benefits the infected person and all others in society. Examples of positive consumption effects include

Education: When a person invests in his education, it not only gives him a private benefit but also makes him a more productive and valuable member of society. This could be in the form of increased productivity, following better social and environmental practices, or contributing to the community as an active member.
Insurance: An insurance contract protects the insured from liabilities and damages. However, in the case of certain insurances like motor insurance, the contract includes provisions for compensation for third parties in case of bodily injuries, accidental deaths, or property damage.
Public Goods: These refer to all goods for public use available for all. When a community invests in public interests like street lighting, it benefits everyone living in the community by decreasing the incidence of crime and accidents. Additionally, it benefits all people passing through the neighborhood who may not have contributed.
Vaccine: A person taking a vaccine reduces his chances of getting infected and the probability of spreading infection in his area.

Negative effects of production and consumption

It refers to all production and consumption activities that create costs for people other than the producers and consumers.

The most common negative effects arising from production are

Air pollution: Commonly arising from factories involved in the burning of fossil fuels or factories releasing untreated pollutants through chimneys. This harms all people living in proximity.
Water pollution: Oil tanker spills and drainage of chemicals in water bodies affect fisheries and related businesses. It also inversely affects people depending on the water source for livelihood and consumption.
Noise pollution: Noise pollution caused by construction projects or airports hurts people living around the area.

Negative consumption activities include-

Smoking: The consumption of cigarettes creates health costs for all people in the vicinity in the form of passive smoke.
Traffic congestion: With an increase in the consumption of cars in big cities, traffic congestion and related perils like accidents increase. This creates a negative effect on all people involved. It also affects others living in congested areas due to the noise pollution caused by excessive honking.
Littering: Another social cost that affects the community is littering. It creates a negative factor for all people living in the area. It may cause environmental degradation, scenic damage, or increase the incidence of diseases.

Equilibrium condition

In the absence of externalities, the equilibrium condition to determine the price of a good is:

Consumers' Benefits = Producers' Cost

P = MC

Where

P = Price of the good
MC = Marginal Cost of producing a unit of the good

The equilibrium condition implies that the price of the goods paid by the consumer must be equal to the marginal cost incurred by the producer on the goods.

However, the presence of a negative external cost creates a Marginal External Cost(MEC) in society.

The equilibrium condition is,

Consumers’ Benefits = Producers’ Cost + Social Cost

P = MC + MEC

P = SMC

SMC = Social Marginal Cost of all factors in the society

i.e., Producers Cost + Social Cost

SMC = MC + MEC

When producers don't account for the social cost, they assume their costs are lower than actual, producing more.

In the case of negative effects, the market tends to overproduce.

The presence of a positive externality creates a Marginal External Benefit(MEB) in society.

The equilibrium condition is,

Consumers’ Benefits + Social Benefit = Producers’ Cost

P + MEB = MC

SMB = MC

SMB = Social Marginal Benefit of all factors in the society, i.e., Private Benefit to the consumer + Social Benefit.

SMB = P + MEB

When consumers don't account for the social benefit, they assume their prices are higher than actual and demand less.

In the case of positive effects, the market tends to underproduce.

Externality Solutions

All externalities need to be managed as they may lead to market failure. Negative costs involve minimizing the damage to third parties through rules and regulations.

The three primary ways to manage and regulate such effects are listed and explained below.

Taxes

The most effective way of managing social costs is the imposition of tax. The government imposes taxes on goods and services, creating an external cost for society. The tax could be on the producers or the consumers.

The objective is to curb the consumption of such goods and solve the problem of overproduction associated with negative externalities.

When the tax is imposed on the consumers, it increases their price, and they consume less. This involves taxes on bad economic effects like alcohol and cigarette consumption.

When taxes are imposed on the producers, they pass the additional cost burden to consumers by increasing the price of the goods. This further discourages consumers and reduces demand.

The tax imposed is also called the Pigouvian Tax, named after the economist behind the concept - Arthur C Pigou. It states that the magnitude of total tax imposed must only be equal to the externality caused.

That is,

Value of Pigouvian Tax = MEC associated with the negative externality

To restore the equilibrium condition,

P = MEC + MC

Clearly defined property rights

It refers to giving one side of the market well-defined property rights over the resource. For example, if a smoker smokes in public, it negatively affects others.

However, if a smoker were to smoke on his private property or at home, he has autonomy on consumption, and any third party cannot object.

In the case of public or natural resources like air and water, it is impossible to assign property rights in favor of one producer.

Thus externalities of air pollution, water pollution, and noise pollution cannot be necessarily resolved using property rights.

Subsidies

This mainly involves positive managing effects. The government or regulating body provides subsidies to producers or consumers to overcome the problem of underproduction in positive externalities.

For example, subsidies on education or government spending encourage people to invest in their education and contribute to society.

Similarly, subsidies to the pharmaceutical sector give incentives to medical companies to invest in more R&D and production of medicines that benefit society.

Regulation

When negative externality effects are critical and affect a large share of the population, the government may resort to using legal jurisdiction.

This involves imposing bans on such activities altogether.

A common example is a ban on smoking in most public places to protect the interest of the common public.

The government may also impose health or environmental regulations to control negative externalities.

The Tragedy of Commons

The most common real-world example of externalities is a situation of the tragedy of commons.

It refers to a situation that has the following characteristics-

All individuals have access to a common resource for their use
One person's consumption creates a negative externality for others as it depletes the total resource
Each acts in his self-interest
The short-term interests of each lead to tragedy for all

The ultimate result of such a situation is the depletion of the resource altogether.

Such a situation arises in the case of overfishing or overhunting.

The actions of each fisherman or hunter without understanding the negative externality cause the species in an area to become extinct over time. This will impact all fishermen and hunters adversely.

Another example of such a situation is the depletion of groundwater resources. As each acts in his self-interest and continues to use the water indiscriminately, it leads to a lack over time.

The tragedy of commons can be resolved by assigning property rights. But unfortunately, this makes the resource a private good whereby the owner will seek to regulate the activities of all other individuals.

Another way to resolve this situation is through government regulations, as is done in the case of environmental resources. The government resorts to overhunting by using bans or regulations on an illegal hunting activity.