In economics, an externality is a cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Many externalities can be considered as unpriced components that are involved in either consumer or producer consumption. Air pollution from motor vehicles is one example. The cost of air pollution to society is not paid by either the producers or users of motorized transport. Water pollution from mills and factories are another example. All (water) consumers are made worse off by pollution but are not compensated by the market for this damage.
The concept of externality was first developed by Alfred Marshall in the 1890s and achieved broader attention in the works of economist Arthur Pigou in the 1920s. The prototypical example of a negative externality is environmental pollution. Pigou argued that a tax, equal to the marginal damage or marginal external cost, (later called a "Pigouvian tax") on negative externalities could be used to reduce their incidence to an efficient level. Subsequent thinkers have debated whether it is preferable to tax or to regulate negative externalities, the optimally efficient level of the Pigouvian taxation, and what factors cause or exacerbate negative externalities, such as providing investors in corporations with limited liability for harms committed by the corporation.
Externalities often occur when the production or consumption of a product or service's private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole. This causes the externality competitive equilibrium to not adhere to the condition of Pareto optimality. Thus, since resources can be better allocated, externalities are an example of market failure.
Externalities can be either positive or negative. Governments and institutions often take actions to internalize externalities, thus market-priced transactions can incorporate all the benefits and costs associated with transactions between economic agents.Jaeger, William. Environmental Economics for Tree Huggers and Other Skeptics, p. 80 (Island Press 2012): "Economists often say that externalities need to be 'internalized,' meaning that some action needs to be taken to correct this kind of market failure." The most common way this is done is by imposing taxes on the producers of the externality. However, since regulators do not always have all the information on the externality, it can be difficult to impose the right tax. Once the externality is internalized through a tax, the competitive equilibrium is Pareto optimal.
History of the concept The term "externality" was first coined by the British economist Alfred Marshall in his seminal work, "Principles of Economics," published in 1890. Marshall introduced the concept to elucidate the effects of production and consumption activities that extend beyond the immediate parties involved in a transaction. Marshall's formulation of externalities laid the groundwork for subsequent scholarly inquiry into the broader societal impacts of economic actions. While Marshall provided the initial conceptual framework for externalities, it was Arthur Pigou, a British economist, who further developed the concept in his influential work, "The Economics of Welfare," published in 1920. Pigou expanded upon Marshall's ideas and introduced the concept of "Pigovian taxes" or corrective taxes aimed at internalizing externalities by aligning private costs with social costs. His work emphasized the role of government intervention in addressing market failures resulting from externalities.
Additionally, the American economist Frank Knight contributed to the understanding of externalities through his writings on social costs and benefits in the 1920s and 1930s. Knight's work highlighted the inherent challenges in quantifying and mitigating externalities within market systems, underscoring the complexities involved in achieving optimal resource allocation. Throughout the 20th century, the concept of externalities continued to evolve with advancements in economic theory and empirical research. Scholars such as Ronald Coase and Harold Hotelling made significant contributions to the understanding of externalities and their implications for market efficiency and welfare.
The recognition of externalities as a pervasive phenomenon with wide-ranging implications has led to its incorporation into various fields beyond economics, including environmental science, public health, and urban planning. Contemporary debates surrounding issues such as climate change, pollution, and resource depletion underscore the enduring relevance of the concept of externalities in addressing pressing societal challenges.
Definitions
A negative externality is any difference between the private cost of an action or decision to an economic agent and the social cost. In simple terms, a negative externality is anything that causes an indirect cost to individuals. An example is the toxic gases that are released from industries or mines, these gases cause harm to individuals within the surrounding area and have to bear a cost (indirect cost) to get rid of that harm. Conversely, a positive externality is any difference between the private benefit of an action or decision to an economic agent and the social benefit. A positive externality is anything that causes an indirect benefit to individuals and for which the producer of that positive externality is not compensated. For example, planting trees makes individuals' property look nicer and it also cleans the surrounding areas.
In microeconomic theory, externalities are factored into competitive equilibrium analysis as the social effect, as opposed to the private market which only factors direct economic effects. The social effect of economic activity is the sum of the indirect (the externalities) and direct factors. The Pareto optimum, therefore, is at the levels in which the social marginal benefit equals the social marginal cost.
Externalities are the residual effects of economic activity on persons not directly participating in the transaction. The consequences of producer or consumer behaviors that result in external costs or advantages imposed on others are not taken into account by market pricing and can have both positive and negative effects. To further elaborate on this, when expenses associated with the production or use of an item or service are incurred by others but are not accounted for in the market price, this is known as a negative externality. The health and well-being of local populations may be negatively impacted by environmental deterioration resulting from the extraction of natural resources. Comparably, the tranquility of surrounding inhabitants might be disturbed by noise pollution from industry or transit, which lowers their quality of life. On the other hand, positive externalities occur when the activities of producers or consumers benefit other parties in ways that are not accounted for in market exchanges. A prime example of a positive externality is education, as those who invest in it gain knowledge and production for society as a whole in addition to personal profit."Microeconomics" by Robert S. Pindyck and Daniel L. Rubinfeld
Government involvement is frequently necessary to address externalities. This can be done by enacting laws, Pigovian taxes, or other measures that encourage positive externalities or internalize external costs. Through the integration of externalities into economic research and policy formulation, society may endeavor to get results that optimize aggregate well-being and foster sustainable growth.
Implications A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected by the negative externalities in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on their health or violating their property rights (by reduced valuation). Thus, an external cost may pose an ethical or political problem. Negative externalities are Pareto inefficient, and since Pareto efficiency underpins the justification for private property, they undermine the whole idea of a market economy. For these reasons, negative externalities are more problematic than positive externalities.
Although positive externalities may appear to be beneficial, while Pareto efficient, they still represent a failure in the market as it results in the production of the good falling under what is optimal for the market. By allowing producers to recognise and attempt to control their externalities production would increase as they would have motivation to do so. With this comes the free rider problem. The free rider problem arises when people overuse a shared resource without doing their part to produce or pay for it. It represents a failure in the market where goods and services are not able to be distributed efficiently, allowing people to take more than what is fair. For example, if a farmer has honeybees a positive externality of owning these bees is that they will also pollinate the surrounding plants. This farmer has a next door neighbour who also benefits from this externality even though he does not have any bees himself. From the perspective of the neighbour he has no incentive to purchase bees himself as he is already benefiting from them at zero cost. But for the farmer, he is missing out on the full benefits of his own bees which he paid for, because they are also being used by his neighbour.
There are a number of theoretical means of improving overall social utility when negative externalities are involved. The market-driven approach to correcting externalities is to internalize third party costs and benefits, for example, by requiring a polluter to repair any damage caused. But in many cases, internalizing costs or benefits is not feasible, especially if the true monetary values cannot be determined.
Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized. Similarly, Ludwig von Mises argues that externalities arise from lack of "clear personal property definition."
Examples
Many externalities arise between producers, between consumers or between consumers and producers. Externalities can be negative when the action of one party imposes costs on another, or positive when the action of one party benefits another.
+Classification of externalitiesConsumptionProductionNegativeNegative externalities in consumptionNegative externalities in productionPositivePositive externalities in consumptionPositive externalities in production
Negative
A negative externality (also called "external cost" or "external diseconomy") is an economic activity that imposes a negative effect on an unrelated third party, not captured by the market price. It can arise either during the production or the consumption of a good or service. Pollution is termed an externality because it imposes costs on people who are "external" to the producer and consumer of the polluting product. Barry Commoner commented on the costs of externalities: Clearly, we have compiled a record of serious failures in recent technological encounters with the environment. In each case, the new technology was brought into use before the ultimate hazards were known. We have been quick to reap the benefits and slow to comprehend the costs.Barry Commoner "Frail Reeds in a Harsh World". New York: The American Museum of Natural History. Natural History. Journal of the American Museum of Natural History, Vol. LXXVIII No. 2, February, 1969, p. 44