Externalities in economics are the indirect cost or benefit that a producer cause to a third party that is not financially incurred or received by the producer. In other words, the term “externalities” refers to a cost or benefit that an unrelated third party experiences from economic activity. This can come in a positive or negative form which stems from either production or consumption of a commodity or service. These costs or benefits can be private, that is to an individual or an organization, or social which implies that it can have an effect on society as a whole.
In economics, externalities occur because of the activities of another party. Externalities in microeconomics can bring about disequilibrium in the market especially when costs outweigh the benefits to an individual or an organization. When externalities are present in a market, the well-being of market participants is directly affected. Private markets fail to account for externalities because they do not have the incentive to account for them.
Generally, economic externalities are environmental in nature (environmental externalities) such as natural resources and public health. For instance, a negative externality brings about pollution that decreases the value of property or people’s health in an area. On the other hand, a positive externality encompasses the actions that bring about a decrease in the transmission of disease or avoids the lawn treatments that runoff into rivers thereby contributing to the excess growth of plants in lakes.
Whenever an economic party engages in activities such as the consumption of a good or service, other parties that were not present in the activity may incur (potential) costs or benefits. So, in essence, if there are potential benefits to be incurred by third parties, then it is called a positive externality. On the other hand, if there are potential costs to be incurred by a third party, then it is called a negative externality.
It is important to note that externalities in economics do not belong in the market where one can buy or sell them, which brings about the missing market. They are immeasurable in quantitative methods as different individuals judge the outcomes of their social costs and benefits in different ways.
Firms can bring about externalities in the course of producing goods that will be sold in the market. This is referred to as production externality. On the other hand, individuals can bring about externalities in business while consuming goods. This is referred to as consumption externalities.
Spillover costs and spillover benefits are also called negative and positive externalities because they occur as a result of the activities of others.
Almost all externalities are viewed as technical externalities.
Technical externalities impact the production and consumption opportunities of third parties that are unrelated. Well, the price of consumption is not included in the externalities. This exclusion brings about a gap between the gain or loss that private individuals incur and the aggregate gain or loss of society at large.
Oftentimes, the actions of an individual or firm can bring about positive private gains, however, it detracts from the overall economy. The external cost or benefit does not reflect in the final cost or benefit of a good or service. All externalities are market failures, but not all market failures are externalities. Because of this, economists generally look at externalities as a serious problem that brings about inefficiencies in the market which leads to market failures. It is for this reason that people advocate for the intervention of governments in order to curtail negative externalities through actions like regulation and taxation.
The Coase theorem asserts that, in the presence of externalities, private economic participants arrive at a bargain which in turn produces an efficient outcome. When externalities exist, buyers and sellers do take into account the impact of their actions, however, the market equilibrium remains efficient. With this, externalities are the effects of the economic actions of an individual or a firm on an unrelated third party. Externalities can distort the true costs and benefits of goods and services.
Examples of positive and negative externalities are discussed in the article.
Types of Externalities
- Positive externalities
- Negative externalities
The above-mentioned are the two basic types of externalities under which there are subdivisions.
Positive externality refers to the benefit that an unrelated third party incurs from economic activity. Although there are benefits that come from economic activities that have to do with positive externality, it also brings about market inefficiencies. An instance is government spending, which takes money away from private hands, directing it to areas where it deems fit.
The external cost here is the fact that individuals and firms will have less disposable income. Although government spending creates a positive externality, potential negative externalities balance it out. This is because fewer funds will be in the hands of the private sector to be able to invest in production equipment.
For example, positive externalities are most likely to be found in the production of milk and dairy products as well as honey because unrelated third party benefits from it. Positive externalities lead markets to produce efficiently. The market demand curve for positive externalities reflects the private benefits of consumers without reflecting the social benefits.
Positive externalities are subdivided into two types namely;
- Positive production externalities
- Positive consumption externalities
Positive production externalities
The positive production externalities in economics take place when a third party incurs benefits from the production of another. The point here is that the third party that benefits cannot be charged. For example, the smell of fresh bread comes out of a bakery through the mall but those that benefit do not get charged for that and there is no way for the baker to charge them either.
Positive consumption externalities
Positive consumption externalities come about when the third party derives benefits from the consumption of somebody else.
Positive externalities examples
The examples of positive externalities discussed below would include some examples from the two types of positive externalities.
Examples of Positive production externalities
- Infrastructure development
- New technology
Infrastructure development is one example of externalities in economics. The act of constructing new businesses and other social amenities may bring about an increase in the value of local properties. In turn, this creates a positive benefit for local residents. Also, this can create jobs that provide income to residents. Furthermore, this will stimulate economic activities in that region. Even if local residents do not make use of such a business, they benefit.
With the advancement of technology, private benefits are inevitable. Many firms derive benefits from productivity gains which have brought about spillover effects.
For instance, if a business spends $10 million on the production of jumpers, it implies that it is possible to spend those resources elsewhere. Instead of spending $10 million on the production of the same number of jumpers, the business can spend it on producing a new style of pants or more staff. These new pants may gain incredible popularity. However, without the initial productivity gains from technology, this would be unachievable.
Employees of a business may be trained to acquire a specific skill with both the business and employees sharing the benefits and productivity gains. If, however, the employee leaves, the new employee will gain benefit from the initial skills and training acquired. Examples could include first aid training and mental health training where third parties will be able to save lives or provide assistance to individuals outside the company. With this, parties from outside the firm can also derive benefits from the training.
A pharmaceutical firm, for instance, may charge high prices because of the costs of research and development as well as risk factors. The other side of it is that it can provide positive external benefits. If a new drug happens to save a life, then it produces a positive private benefit to the company and the individual that was saved. Simultaneously, other parties will benefit. An example of the benefits is that there will be no more fear in the hearts of family and friends with regard to losing a close friend or loved one and the grief that it would birth.
Research and development
If through research and development, a company discovers a new technology, society derives benefits that are helpful.
Examples of positive consumption externalities
- Vaccination and local hygiene
When big firms advertise, it helps in solving the problem of market failure. For example, when one is watching a YouTube video, he is benefiting from the advertisers paying YouTube. Although adverts can be annoying, they allow the masses to view and use such services for free.
The acquisition of any form of education has the potential of benefiting a third party. For example, when we learn how to read and write at school, this is beneficial to society as a whole because we communicate with one another more effectively. If we were uneducated, we would not have the ability to read nor would we communicate effectively with one another.
For every article that is being posted or read, we are the third party that benefits from the knowledge acquired by the poster. Also, an increase in the level of an individual’s education can bring about a rise in economic productivity as well as reduce the rate of unemployment. If education produces positive externalities, we would expect the government to subsidize education because there are positive externalities from higher education.
An insurance policy can bring about a positive externality. For example, if a reckless driver damages a third party’s vehicle, this can be a worrisome situation as the worth of the damages may be huge. If insurance is absent, both parties will have to incur the cost. Another issue is that the reckless driver may not have the means of paying for the damages. This implies that the reckless driver has imposed a cost on the third party. With insurance, this issue will be resolved. Here, if a third party sustains an injury or damage to his car, they can make a claim.
Receiving vaccinations as well as taking steps to prevent oneself from contracting a contagious disease, passes a benefit to the third party. In turn, this reduces the likelihood of spreading disease.
Negative externalities are created when the economic activity of an individual or a firm imposes a cost on a third party without prior knowledge or consent. In other words, it is the negative consequence that a third party experiences as a result of economic activity. When negative externalities are present in a market negative consequences come about, especially when the third party is not compensated for those costs. Because of this, governments generally try to step in to resolve those issues.
It is generally unfair for one to have to pay for somebody else’s fault. A market with negative externalities will tend to be inefficient. In other words, when negative externalities are present in a market, inefficiencies occur due to the negative consequences.
According to the Coase theorem, when negative externalities are present, a market will arrive at an efficient solution if the costs of the transaction are low and there is a proper definition of property rights. Private markets with negative externalities are inefficient because the equilibrium price of a good or service does not give an accurate reflection of the true costs and benefits of that good or service. Negative externalities lead markets to produce inefficiently.
Generally, the majority of the externalities are negative and are also subdivided into two;
- Negative production Externalities
- Negative consumption externalities
Negative production externalities
These are negative externalities that come about when a third party incurs costs from the production of another. For example, air pollution may result from the production activities of a firm.
Negative consumption externalities
Negative consumption externalities come as a result of someone else’s consumption of a product where the social cost of consuming that product exceeds the private benefit. Private benefits are positive factors rewarded to the producer or consumer of a product. Social costs are the negative factors that affect third parties.
An example is when a person consumes alcohol and becomes drunk, he will bring about social disorder thereby disturbing the peace of non-drunkards. In essence, when negative externalities exist in a market there will be market failure. Zoning laws might be justified in dealing with the problem of negative externalities because they can regulate the activities of firms and individuals.
Negative externalities examples
The examples of negative externalities are explained thus;
Examples of negative production externalities
Factories may bring about air pollution as they release harmful gases such as carbon monoxide and carbon dioxide into the atmosphere. These air pollutants can bring about damage to crops, buildings, and human health.
Also, when greenhouse gases are concentrated in the atmosphere, it has an effect on the global climate which brings about extreme heat waves, rising sea levels, graded air quality, intense hurricanes, and droughts. Vulnerable populations such as children, the elderly, and patients suffering from asthma and heart diseases are being affected by the release of toxic gases into the atmosphere. In essence, when a factory burns fossils to produce goods, nearby residents and workers suffer as air quality deteriorates.
When industrial wastes are released into public waterways, it brings about pollution which is harmful to humans, plants, and animals that depend on it. Usually, factory wastes contain chemicals that are toxic and this can kill aquatic animals. In turn, this will deny fishermen a source of income. Plants are also affected by contaminated water as they rely on water to survive. Also to human life, drinking contaminated water will pose a threat to human life as well as cause life-threatening diseases, and even death.
Noise pollution is another example of production negative externalities. For example, people that live close to a factory or large airports may suffer high levels of noise. This noise can be harmful to those suffering from high blood pressure and heart conditions.
Farm animal production
Raising farm animals is also bound to cause harm to third parties residing close to the farm. An instance is where the misuse of antibiotics can bring about a large pool of bacteria that are antibiotic-resistant. These bacteria may spread outside the farm and cause diseases to other animals. Also, when animal wastes are dumped, they can leak and contaminate rivers and streams thereby causing the water to be unsafe for human use and consumption.
Negative consumption externalities examples
Examples of the negative externalities of consumption include;
- Smoking and air pollution
- Rising obesity
- Traffic congestion
- Noise pollution
Smoking and air pollution/passive smoking
This slightly differs from industrial pollution. Smoking is a form of consumption that has an impact on a third party. These effects can have a higher risk of cancer both for the individual smoking and those inhaling the fumes.
Higher levels of obesity are associated with health conditions that include heart diseases. Although it is a private cost, it can impose additional costs on third parties. It is as a result of obesity that family members, relatives, or friends will have to pay for treatments and this can take the form of higher insurance costs.
Oftentimes, people throw the leftover package of a food item or beverage on the floor. This then imposes a cost to the average passerby which takes the form of an unpleasant sight. This has an impact on the natural environment, distorting it.
Traffic congestion comes as a result of the use of vehicles. The more vehicles are being used on roads, the heavier the traffic congestion becomes. This brings about delays and slower movements. Also, the likelihood of accidents increases.
For example, music coming from nightclubs can be a nuisance to those who are not part of the participants. Loud music can disrupt one mentally and psychologically, especially for children who have not adapted to the surrounding environment. Noise pollution may also deprive one of sleep as well as affect the productivity of nearby residents and businesses.
In essence, the difference between positive and negative externalities is that positive externalities are benefits that an unrelated third party incurs from the economic activities of a firm, while negative externalities are costs incurred by an unrelated third party from the economic activities of an individual or a firm.
Solutions to externalities
- Defining property rights
- Merger and internalization
Because of the fact that both positive and negative externalities possess adverse effects, policymakers and economists look toward addressing the problem. Internalization has to do with the process of adopting policies that would reduce the adverse effects of externalities on unrelated third parties. Generally, it takes government intervention to achieve this internalization. All remedies for externalities share the goal of moving resource allocation towards the social optimum.
According to the Coase theorem, private parties can solve the problem of externalities if there are no transaction costs. One reason that private solutions to externalities do not always work is that most individuals and firms do not cooperate as well as be moral in their acts. Therefore, two types of private solutions to the problem of externalities are charities and moral codes.
Explaining the solutions;
Defining property rights
When there is a strict definition of property rights, this can limit the impact that economic activities have on unrelated third parties. The disadvantage of this measure is that it is not always viable because one cannot assign the ownership of things such as air or water to a particular agent. This option is only effective if one owns something like a fishery, which can be defined. If, for example, a fishery owner gets affected by downstream pollution from an industrial firm, he can sue the industrial firm in order to receive compensation for the effect it had. In this case, they can arrive at a settlement where reimbursement takes place for that externality.
Governments can impose taxes on goods and services that bring about externalities. The reason is for the taxes to discourage activities that impose costs on unrelated third parties. The taxes paid can then be used to pay for positive externalities such as education as well as other public goods.
To stimulate certain activities, a government can make provisions for subsidies. These subsidies aim to increase the consumption of goods that possess positive externalities by making them more affordable. Some goods are being underproduced because private individuals do not value them so much. This means that there is an underproduction of positive externalities when the whole social benefit exceeds the private benefit. Subsidies help in resolving the issue.
Regulation is another remedy to externalities. In this case, the government can make negative externalities illegal as well as address some of the side effects that result which in turn will reduce the consumption or production of such goods and services. For example, many countries have declared smoking in public places illegal which has helped in reducing the effects of passive smoking. In this case, we can consider regulation as the most common solution. This makes the public turn to governments to pass and create legislation that will curb negative externalities.
Merger and internalization (internalize the externalities)
One solution to the problem of allocational distortions that an externality between two or more companies caused is the merger. If a single firm operates for separate companies, say it operates both plants A and B, it will be able to recognize the negative impact that the production of B has on the production of A. This is where the internalization of externalities comes in.
In internalizing externalities, the newly merged firm will bear the full social costs of the production of B because it also produces A now. When externalities are present, this can bring about inefficiencies in the operations of markets. According to the Coase theorem, in the presence of externalities, private parties will arrive at an efficient outcome without the government intervening.
Encouraging positive externalities
As earlier pointed out, governments can play a vital role in the encouragement of positive externalities through the provision of subsidies for goods that generate spillover benefits.
Subsidies lower the cost of producing a particular good or service. They provide the incentive for a firm to increase the production of goods that possess positive externalities. Because spillover benefits spread across society, government subsidies are effective ways of encouraging positive externalities where society shares in the cost of generating positive externalities. Besides, society pays the taxes that fund the subsidies.
When it comes to education, the government subsidizes public education. It is for this reason that education is produced and consumed as well as society reaping spillover benefits. Governments can increase the consumption of a product that creates positive externalities by providing subsidies for those goods. Other than correcting externalities, other economic functions of government include fiscal policies.
It is for this reason that we determine positive or negative externalities based on whether costs or benefits spill over.
FAQs on externalities
What are externalities?
Externalities are the indirect cost or benefit that a producer causes to a third party that is not financially incurred or received by the producer.
What are the 4 types of externalities?
The four types of externalities are Positive production externalities, positive consumption externalities, negative production externalities, and negative consumption externalities.
How do externalities affect you?
Externalities can bring about a decrease in the value of home properties as well as cause trouble for businesses in society. Due to these externalities, cities can look unappealing. They would have looked cleaner if everyone played their role and cleaned up their own mess. In almost every facet of life, externality affects us either positively or negatively.
How do network externalities affect barriers to entry?
Network externalities bring about barriers to entry. This is because if a firm is initially able to attract enough customers, it will be able to attract additional customers as the value of its product increases with more people using it, which attracts more customers.
What is the consequence of externalities?
Generally, externalities will make competitive markets inefficient in their behaviors from a social perspective, thereby creating market failure. In other words, a competitive market does not yield a socially efficient outcome. In essence, externalities tend to cause markets to be inefficient. Education, however, creates an important positive externality.
When are we likely to see private solutions to the problem of externalities?
We are likely to see private solutions to externalities when there is cooperation between the parties involved, moral codes in society, and charity. This calls for the act of being considerate about the effect one’s activity will have on the other.
What are network externalities and how do they lead to growth?
Network externalities are situations whereby a change in the number of users brings about a change in the value of a product. This implies that it affects growth in the number of users. The value of a product can increase when users increase and vice-versa. However, negative network externalities occur when more users bring about a decrease in the value of a product.
What are positive externalities?
Positive externalities definition is the benefits that an unrelated third party incurs from economic activity.
When are negative externalities present?
Negative externalities are present when economic activities cause an unrelated third party to incur costs.
What are network externalities?
Network externalities are situations whereby there is a change in the value of products or services as a change occurs in the number of users. Network externalities exist when a product or service becomes less expensive as more people make use of it.
In what sense do externalities cause the “invisible hand” of the marketplace to fail?
When externalities exist, markets fail to produce the maximum total benefit to society and because of that, the invisible hand of the marketplace fails. In the absence of externalities, the “invisible hand” leads a market to maximize output in the market. The “invisible hand” is responsible for the efficient allocation of resources in the market when buyers and sellers are the only interested party. However, government intervention may bring about an improvement in the market outcome in the presence of externalities.
What are negative externalities?
Negative externalities definition is the costs that an unrelated third party incurs from the economic activities of another party. In other words, when externalities cause markets to be inefficient, it implies a negative externality.
What are the sources of externalities and market failure?
Externalities come from the production and consumption of a good or service which brings about a benefit or cost to an unrelated third party. Market failure stems from inefficiencies in the distribution of goods and services in the market.
How do property rights affect externalities and market failure?
Defining property rights can limit the impact that economic activities have on unrelated third parties.
What happens when network externalities are present?
There will be an increase in the usefulness of a product as well as the number of consumers who make use of it. Network externalities exist when a product or service becomes less expensive as more people use it
How are network externalities and the number of competitors in an oligopoly related?
Usually, the first firm in the market will experience a quick growth in its customers thereby making it more difficult for subsequent/new entrants to gain customers. There are few competitors in oligopolies, and because of that, network externalities will be in favor of the first entrants to a market in an oligopoly.