Definition of Externalities
Externalities are "side effects" or "spillover effects" from economic activities.
The term is often used when discussing costs or benefits present in an activity, but the parties involved do not consider them.
In particular, the term is used in environmental economics to describe both positive and negative consequences of transactions not felt directly by a party involved in a transaction.
Types of Externalities and Examples
Externalities may be classified as positive or negative in consumption and production.
Positive Externality
Also known as "beneficial externality" or "surplus externality", a positive externality is created whenever an individual or firm produces a good with beneficial consequences for others.
An example of a positive externality in production is a firm conducting research and developing new technology. Since the invention is available for use by society, all of society benefits from the development.
An example of a positive externality in consumption is using a bicycle or walking to work rather than use a vehicle. It not only benefits the person making that choice, but also helps reduce pollution which is positive for everyone.
Negative Externality
Also known as "adverse externality" or "external diseconomy", a negative externality is created whenever an individual or firm produces a good with harmful consequences for others.
The side effects are not reflected in market prices because they are external to the market.
An example of a negative externality in production is air pollution caused by factories. Factory owners only take their health and safety into account when producing a good while ignoring the clean air of bystanders. Consumers do not pay for the increased risk to their health from pollution in the price of a good, resulting in a negative externality.
An example of a negative externality in consumption is passive smoking. Smokers only consider the increased risk to their health while smoking, not the general decline in air quality for others nearby.
The Free-Rider Problem
The free-rider problem arises when people who benefit from an externality do not contribute to the cost of maintaining that good.
An example of this is when a person builds a lighthouse. The person who builds the lighthouse privately benefits from it, but so do all ships at sea since they can use it to avoid danger. However, although everyone else uses it, no one would want to build a lighthouse if they had to pay for its entire cost alone because it would not be worth it.
In this case, the producer’s private benefit does not account for social costs or benefits associated with their production or consumption.
It can be argued that if people do not pay for the social costs of their decisions, they will act to make themselves better off, all the while not caring about the impact on others, ultimately resulting in making society worse off.
Addressing Externalities
Because externalities have implications for efficiency, they are important to consider when making economic policy.
Below are some means to address externalities in a cost-effective way:
Implementing Regulations
One way to deal with externalities is by introducing or enforcing regulations on an activity that has harmful external effects.
Examples of these regulations are environmental regulations, laws against littering, and laws regarding the use of endangered species.
This option is used when externalities are negative because it removes the positive incentive to produce a good or utilize a service with a harmful externality.
Subsidies
Subsidies encourage the consumption of a good that has a positive externality.
For example, recycling is subsidized because the government pays people to take their recyclables and turn them into new products instead of throwing them away.
Pigouvian Taxes
Another method that can decrease negative externalities is the introduction of taxes on goods where production and/or consumption have a negative impact on society.
This tax is called a Pigouvian tax, named after economist Arthur C. Pigou who was the first to formalize how taxes can deal with negative externalities.
Pigouvian taxes are an economically efficient method of bargaining for reductions in negative externalities because they allow market prices to reflect social costs and benefits when producing goods.
Using this method will decrease consumers’ demand of products with negative externalities, while rewarding products that have positive externalities.
When society's marginal benefit (MB) exceeds its marginal cost (MC), it makes sense for government intervention through Pigouvian taxation.
One difficulty in designing such taxes though is knowing what level to set them at to produce the desired outcome.
Consumption Taxes
A final method of addressing externalities is introducing or increasing consumption taxes on goods that contribute negatively to society.
Instead of taxing the goods themselves, this taxation scheme would increase the prices paid by consumers to decrease overall demand for those products.
This method is more effective than Pigouvian taxation when there are very few substitutes (or none at all) for products with negative externalities. It reduces harm to consumers without reducing supply as much as Pigouvian taxes.
Final Thoughts
Negative externalities are not often considered when making economic policies because they can be difficult to measure.
However, it is important to understand the implications of these adverse side effects because they affect society as a whole and not solely those engaged in producing or consuming a good.
The overarching goal of dealing with externalities is to help manufacturers produce efficiently while reducing activity associated with negative externalities.
Governments can use three different policies to address this problem: taxes, subsidies, and regulation.
However, the ultimate goal should be to lessen negative externalities through non-government means because these policies often create inefficiencies and unintended consequences.
FAQs
1. Why is "free-riding" positive externalities a problem?
The free-rider problem refers to the situation where everyone can benefit from goods or services without paying for them. Since people do not have to contribute financially, they are more likely to abuse the system and "free-ride" off others' contributions.
This causes problems in paying for public goods like defense, police protection, sanitation, among other things.
2. How is the free-rider problem associated with externalities?
One instance where this problem is most prevalent is in the case of pollution. Since no one has to pay for the cost of polluting the atmosphere, it becomes increasingly difficult to find someone who will voluntarily clean it up.
The central question here is which entity should bear the cost of mitigating the externality (the person creating the externality or society as a whole)?
3. How does excessive use affect externalities?
Many goods that produce negative externalities are addictive and lead to overuse because people do not always recognize when enough is enough.
For example, smoking cigarettes creates a significant amount of second-hand smoke when excessive amounts are consumed, thus making it difficult for others (especially those with sensitive respiratory systems) to breathe.
4. How do positive externalities affect society?
Positive externalities exist when a market activity has benefits beyond those involved in producing or consuming it. For example, donating to charities helps create jobs and support local communities, making society as a whole better off.
5. How do negative externalities affect society?
Negative externalities are often one of the main reasons why market prices do not accurately reflect social costs and benefits. For example, pollution has real impacts on people's health, decreasing the quality of life (thus invoking negative externalities).
