Externalities can have a significant impact on the economy. They can cause economic growth or decline and raise or lower costs for businesses and consumers. It is important to consider the implications of externalities when making economic decisions. 

What is an externality? 

Externalities are the costs or benefits of economic activity perceived by unaffiliated third parties. An item or service’s ultimate cost or benefit does not consider the external benefit or cost. 

As externalities render markets inefficient and ultimately cause market failures, economists typically consider them a severe issue. Externalities mostly cause the agony of the commons. Externalities can be positive or negative and can affect individuals or businesses. 

Understanding externality 

The two people involved in an economic transaction are rarely the only ones impacted by it. While certain market processes require either one or both parties to consider these impacts, there are numerous situations where neither party is required to examine the implications of their decisions. In these circumstances, those not directly participating in the transaction must deal with what is known as economic externalities. 

Most externalities fall under the category of “technical externalities,” meaning that although their indirect effects influence other people’s options for consumption and production, the product’s price does not account for them. As a result, there are variations in the costs or returns to the private sector and those to society as a whole. 

Although a person or organisation’s actions frequently provide favourable private profits, they harm the economy as a whole. Those who support government involvement to reduce negative externalities through taxes and regulation do so because many economists view technological externalities as market imperfections. 

Types of externalities 

Externalities are often characterised as either positive or negative. 

  • Positive externality 

When both the social and private sectors benefit, there are positive externalities. An economy with a positive externality is one in which the market participants do not fully capture the benefits of economic activity. Instead, there are spill-over benefits that accrue to society as a whole.  

A classic example of a positive externality is education. The individual student does not just enjoy the benefits of education – they are also enjoyed by society by producing more educated and productive citizens. 

Positive externalities are often considered a market failure because they lead to an inefficient allocation of resources. This is because the market participants do not consider the full social benefits of their activity when deciding how to allocate their resources. As a result, too little of the activity takes place from the standpoint of society as a whole. 

  • Negative externality 

Most externalities are negative. These externalities are unfavourable effects of economic activity felt by unaffiliated third parties. A typical and most common negative externality is pollution. By developing new processes that are more negative to the environment, a company may choose to reduce expenses and boost revenues. But, the company also earns higher returns than the costs due to increasing activities. 

Production externalities and consumption externalities are additional categories for negative externalities. Production externalities may include air pollution, water pollution, and noise pollution, and consumption externalities may include passive smoking and traffic congestion. 


Solutions to externalities 

Both positive and negative externalities negatively impact market efficiency; thus, policymakers and economists seek solutions. Adopting regulations to lessen the impact of externalities on unaffiliated parties is the procedure of “internalising” externalities. Usually, government involvement is used to accomplish internalisation. The following are some potential fixes: 

  • Taxes 

One way to deal with externalities is through taxes. The government can levy taxes on products or services that cause externalities. The taxes would deter actions that burden unaffiliated parties with expenses. 

The tax, known as a “Pigovian tax” after economist Arthur C. Pigou, is thought to be equivalent to the cost of the unfavourable externality. Applying this kind of tax will lower the externality’s market impact to a level viewed as efficient. 

  • Subsidies 

Subsidies can also reduce negative externalities by promoting the consumption of positive externalities. To promote certain activities, a government may also offer subsidies. Increasing consumption of commodities with favourable externalities is frequently accomplished through subsidies. 

Governments can also enact regulations to lessen the impact of externalities.  

Overcoming externalities 

The government may prevent negative externalities by taxing products and services that result in spill-over costs. Additionally, the government may promote positive externalities by providing subsidies for products and services with positive spill-over effects. 

Frequently Asked Questions

Negative externalities, such as pollution, can lead to higher costs for everyone in the economy. Businesses that produce pollution do not have to pay for the damage they cause. This means that pollution costs are passed on to everyone else in the form of higher prices for goods and services and lower quality of life. 

Positive externalities, such as education, can lead to economic growth. Educated workers are more productive and can create new businesses and jobs. Education also leads to a healthier workforce, which can lower healthcare costs. 

Most externalities are negative since the industrial process frequently results in waste, by-products, and other unfavourable effects. The most typical externality of commodities production and consumption is pollution. The environment and others are badly impacted by pollution, such as smoke from product manufacture and garbage overflowing into water. 

The failure of people, households, and companies to internalise the indirect costs or benefits of their economic interactions results in externalities, which pose fundamental difficulties for economic policy. Market results are inefficient due to the wedges between societal and privatised costs or returns. 

Examples of externalities may include: 

  • In addition to producing commodities, factories also pollute the air and water. 
  • While the production of products boosts welfare, pollution has the opposite effect. 

The cost of damages and the cost of control are the principal quantitative techniques economists employ to evaluate externalities. In case of an oil spill, the cost of damages method, for instance, assigns a cost to the clean-up required to remove the pollutants and return the habitat to its pre-oil spill condition. The cost of control technique, on the other hand, substitutes the costs of externality control for any potential damages. 


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