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In
economics Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and intera ...
, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced goods involved in either consumer or producer market transactions.
Air pollution Air pollution is the contamination of air due to the presence of substances in the atmosphere that are harmful to the health of humans and other living beings, or cause damage to the climate or to materials. There are many different types ...
from
motor vehicle A motor vehicle, also known as motorized vehicle or automotive vehicle, is a self-propelled land vehicle, commonly wheeled, that does not operate on Track (rail transport), rails (such as trains or trams) and is used for the transportation of pe ...
s is one example. The cost of air pollution to society is not paid by either the producers or users of motorized transport to the rest of society. Water pollution from mills and factories is another example. All consumers are all made worse off by pollution but are not compensated by the market for this damage. A positive externality is when an individual's consumption in a market increases the well-being of others, but the individual does not charge the third party for the benefit. The third party is essentially getting a free product. An example of this might be the apartment above a bakery receiving the benefit of enjoyment from smelling fresh pastries every morning. The people who live in the apartment do not compensate the bakery for this benefit. The concept of externality was first developed by economist
Arthur Pigou Arthur Cecil Pigou (; 18 November 1877 – 7 March 1959) was an English economist. As a teacher and builder of the School of Economics at the University of Cambridge, he trained and influenced many Cambridge economists who went on to take chair ...
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 A Pigouvian tax (also spelled Pigovian tax) is a tax on any market activity that generates negative externalities (i.e., external costs incurred by the producer that are not included in the market price). The tax is normally set by the government ...
") 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 Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engine ...
. 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. The most common way this is done is by imposing taxes on the producers of this externality. This is usually done similar to a quote where there is no tax imposed and then once the externality reaches a certain point there is a very high tax imposed. 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 imposing a tax the competitive equilibrium is now Pareto optimal. For example, manufacturing activities that cause
air pollution Air pollution is the contamination of air due to the presence of substances in the atmosphere that are harmful to the health of humans and other living beings, or cause damage to the climate or to materials. There are many different types ...
impose health and clean-up costs on the whole society, whereas the neighbors of individuals who choose to fire-proof their homes may benefit from a reduced risk of a fire spreading to their own houses. If external costs exist, such as
pollution Pollution is the introduction of contaminants into the natural environment that cause adverse change. Pollution can take the form of any substance (solid, liquid, or gas) or energy (such as radioactivity, heat, sound, or light). Pollutants, the ...
, the producer may choose to produce more of the product than would be produced if the producer were required to pay all associated environmental costs. Because responsibility or consequence for self-directed action lies partly outside the self, an element of
externalization In Freudian psychology, externalization is an unconscious defense mechanism by which an individual projects their own internal characteristics onto the outside world. It may refer to: * Externalization (migration), efforts by countries to prevent ...
is involved. If there are external benefits, such as in
public safety Public security or public safety is the prevention of and protection from events that could endanger the safety and security of the public from significant danger, injury, or property damage. It is often conducted by a state government to ensure ...
, less of the good may be produced than would be the case if the producer were to receive payment for the external benefits to others.


History of the concept

Two British economists are credited with having initiated the formal study of externalities, or "spillover effects":
Henry Sidgwick Henry Sidgwick (; 31 May 1838 – 28 August 1900) was an English utilitarian philosopher and economist. He was the Knightbridge Professor of Moral Philosophy at the University of Cambridge from 1883 until his death, and is best known in philos ...
(1838–1900) is credited with first articulating, and
Arthur C. Pigou Arthur Cecil Pigou (; 18 November 1877 – 7 March 1959) was an English economist. As a teacher and builder of the School of Economics at the University of Cambridge, he trained and influenced many Cambridge economists who went on to take chair ...
(1877–1959) is credited with formalizing the concept of externalities. The word externality is used because the effect produced on others, whether in the form of profits or costs, is external to the market.


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 Indirect costs are costs that are not directly accountable to a cost object (such as a particular project, facility, function or product). Like direct costs, indirect costs may be either fixed or variable. Indirect costs include administration, pers ...
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.


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 Air pollution is the contamination of air due to the presence of substances in the atmosphere that are harmful to the health of humans and other living beings, or cause damage to the climate or to materials. There are many different types ...
will see it as lowered
utility As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosopher ...
: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a
trespass Trespass is an area of tort law broadly divided into three groups: trespass to the person, trespass to chattels, and trespass to land. Trespass to the person historically involved six separate trespasses: threats, assault, battery, wounding ...
on their health or violating their property rights (by reduced valuation). Thus, an external cost may pose an
ethical Ethics or moral philosophy is a branch of philosophy that "involves systematizing, defending, and recommending concepts of right and wrong behavior".''Internet Encyclopedia of Philosophy'' The field of ethics, along with aesthetics, concerns ma ...
or
political Politics (from , ) is the set of activities that are associated with making decisions in groups, or other forms of power relations among individuals, such as the distribution of resources or status. The branch of social science that studies ...
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 ''Laissez-faire'' ( ; from french: laissez faire , ) is an economic system in which transactions between private groups of people are free from any form of economic interventionism (such as subsidies) deriving from special interest groups. ...
economists such as
Friedrich Hayek Friedrich August von Hayek ( , ; 8 May 189923 March 1992), often referred to by his initials F. A. Hayek, was an Austrian–British economist, legal theorist and philosopher who is best known for his defense of classical liberalism. Haye ...
and
Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
sometimes refer to externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized. Similarly,
Ludwig von Mises Ludwig Heinrich Edler von Mises (; 29 September 1881 – 10 October 1973) was an Austrian School economist, historian, logician, and Sociology, sociologist. Mises wrote and lectured extensively on the societal contributions of classical liberali ...
argues that externalities arise from lack of "clear personal property definition."


Examples

Externalities may 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.


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. 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 Barry Commoner (May 28, 1917 – September 30, 2012) was an American cellular biologist, college professor, and politician. He was a leading ecologist and among the founders of the modern environmental movement. He was the director of the ...
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.
Many negative externalities are related to the environmental consequences of production and use. The article on
environmental economics Environmental economics is a sub-field of economics concerned with environmental issues. It has become a widely studied subject due to growing environmental concerns in the twenty-first century. Environmental economics "undertakes theoretical or ...
also addresses externalities and how they may be addressed in the context of environmental issues.


Negative production externalities

Examples for negative production externalities include: *
Air pollution Air pollution is the contamination of air due to the presence of substances in the atmosphere that are harmful to the health of humans and other living beings, or cause damage to the climate or to materials. There are many different types ...
from burning fossil fuels. This activity causes damages to crops, materials and (historic) buildings and public health. *
Anthropogenic climate change In common usage, climate change describes global warming—the ongoing increase in global average temperature—and its effects on Earth's climate system. Climate change in a broader sense also includes previous long-term changes to E ...
as a consequence of
greenhouse gas emissions Greenhouse gas emissions from human activities strengthen the greenhouse effect, contributing to climate change. Most is carbon dioxide from burning fossil fuels: coal, oil, and natural gas. The largest emitters include coal in China and lar ...
from the burning of fossil fuels and the rearing of livestock. The ''
Stern Review The Stern Review on the Economics of Climate Change is a 700-page report released for the Government of the United Kingdom on 30 October 2006 by economist Nicholas Stern, chair of the Grantham Research Institute on Climate Change and the Environm ...
on the Economics of Climate Change'' says "Climate change presents a unique challenge for economics: it is the greatest example of
market failure In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where indiv ...
we have ever seen." *
Water pollution Water pollution (or aquatic pollution) is the contamination of water bodies, usually as a result of human activities, so that it negatively affects its uses. Water bodies include lakes, rivers, oceans, aquifers, reservoirs and groundwater. Water ...
from industrial effluents can harm plants, animals, and humans *
Spam emails Email spam, also referred to as junk email, spam mail, or simply spam, is unsolicited messages sent in bulk by email (spamming). The name comes from a Monty Python sketch in which the name of the canned pork product Spam is ubiquitous, unavoida ...
during the sending of unsolicited messages by email. *
Noise pollution Noise pollution, also known as environmental noise or sound pollution, is the propagation of noise with ranging impacts on the activity of human or animal life, most of them are harmful to a degree. The source of outdoor noise worldwide is main ...
during the production process, which may be mentally and psychologically disruptive. *
Systemic risk In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to the risk associated with any one individual entity, group or component of a system, that can be contained therein without harming the ...
: the risks to the overall economy arising from the risks that the banking system takes. A condition of
moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...
can occur in the absence of well-designed
banking regulation Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they ...
, or in the presence of badly designed regulation. * Negative effects of Industrial farm animal production, including "the increase in the pool of antibiotic-resistant bacteria because of the overuse of antibiotics; air quality problems; the contamination of rivers, streams, and coastal waters with concentrated animal waste; animal welfare problems, mainly as a result of the extremely close quarters in which the animals are housed." * The depletion of the stock of fish in the ocean due to
overfishing Overfishing is the removal of a species of fish (i.e. fishing) from a body of water at a rate greater than that the species can replenish its population naturally (i.e. the overexploitation of the fishery's existing fish stock), resulting in th ...
. This is an example of a
common property resource In economics, a common-pool resource (CPR) is a type of good consisting of a natural or human-made resource system (e.g. an irrigation system or fishing grounds), whose size or characteristics makes it costly, but not impossible, to exclude potenti ...
, which is vulnerable to the
tragedy of the commons Tragedy (from the grc-gre, τραγῳδία, ''tragōidia'', ''tragōidia'') is a genre of drama based on human suffering and, mainly, the terrible or sorrowful events that befall a main character. Traditionally, the intention of tragedy ...
in the absence of appropriate environmental governance. * In the United States, the cost of storing
nuclear waste Radioactive waste is a type of hazardous waste that contains radioactive material. Radioactive waste is a result of many activities, including nuclear medicine, nuclear research, nuclear power generation, rare-earth mining, and nuclear weapons r ...
from
nuclear plant A nuclear power plant (NPP) is a thermal power station in which the heat source is a nuclear reactor. As is typical of thermal power stations, heat is used to generate steam that drives a steam turbine connected to a generator that produces elec ...
s for more than 1,000 years (over 100,000 for some types of nuclear waste) is, in principle, included in the cost of the electricity the plant produces in the form of a fee paid to the government and held in the nuclear waste superfund, although much of that fund was spent on
Yucca Mountain nuclear waste repository The Yucca Mountain Nuclear Waste Repository, as designated by the Nuclear Waste Policy Act amendments of 1987, is a proposed deep geological repository storage facility within Yucca Mountain for spent nuclear fuel and other high-level radioac ...
without producing a solution. Conversely, the costs of managing the long-term risks of disposal of chemicals, which may remain hazardous on similar time scales, is not commonly internalized in prices. The USEPA regulates chemicals for periods ranging from 100 years to a maximum of 10,000 years.


Negative consumption externalities

Examples of negative consumption externalities include: *
Noise pollution Noise pollution, also known as environmental noise or sound pollution, is the propagation of noise with ranging impacts on the activity of human or animal life, most of them are harmful to a degree. The source of outdoor noise worldwide is main ...
: Sleep deprivation due to a neighbor listening to loud music late at night. *
Antibiotic resistance Antimicrobial resistance (AMR) occurs when microbes evolve mechanisms that protect them from the effects of antimicrobials. All classes of microbes can evolve resistance. Fungi evolve antifungal resistance. Viruses evolve antiviral resistance. ...
, caused by increased usage of antibiotics: Individuals do not consider this efficacy cost when making usage decisions. Government policies proposed to preserve future antibiotic effectiveness include educational campaigns, regulation,
Pigouvian taxes A Pigouvian tax (also spelled Pigovian tax) is a tax on any market activity that generates negative externalities (i.e., external costs incurred by the producer that are not included in the market price). The tax is normally set by the governmen ...
, and patents. *
Passive smoking Passive smoking is the inhalation of tobacco smoke, called secondhand smoke (SHS), or environmental tobacco smoke (ETS), by persons other than the intended "active" smoker. It occurs when tobacco smoke enters an environment, causing its inhalat ...
: Shared costs of declining health and vitality caused by smoking or alcohol abuse. Here, the "cost" is that of providing minimum social welfare. Economists more frequently attribute this problem to the category of
moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...
s, the prospect that parties insulated from risk may behave differently from the way they would if they were fully exposed to the risk. For example, individuals with insurance against automobile theft may be less vigilant about locking their cars, because the negative consequences of automobile theft are (partially) borne by the insurance company. *
Traffic congestion Traffic congestion is a condition in transport that is characterized by slower speeds, longer trip times, and increased vehicular queueing. Traffic congestion on urban road networks has increased substantially since the 1950s. When traffic de ...
: When more people use public roads, road users experience congestion costs such as more waiting in traffic and longer trip times. Increased road users also increase the likelihood of road accidents. * Price increases: Consumption by one party causes prices to rise and therefore makes other consumers worse off, perhaps by preventing, reducing or delaying their consumption. These effects are sometimes called "
pecuniary externalities A pecuniary externality occurs when the actions of an economic agent cause an increase or decrease in market prices. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young ...
" and are distinguished from "real externalities" or "technological externalities". Pecuniary externalities appear to be externalities, but occur within the market mechanism and are not considered to be a source of
market failure In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where indiv ...
or inefficiency, although they may still result in substantial harm to others. * Weak
public infrastructure Public infrastructure is infrastructure owned or available for use by the public (represented by the government). It is distinguishable from generic or private infrastructure in terms of policy, financing, purpose, etc. Public infrastructure is ...
, air pollution, climate change, work misallocation, resource requirements and land/space requirements as in the
externalities of automobiles The externalities of automobiles, similarly to other economic externalities, are the measurable difference in costs for other parties to those of the car proprietor, such costs not taken into account when the proprietor opts to drive their car. A ...
.


Positive

A positive externality (also called "external benefit" or "external economy" or "beneficial externality") is the positive effect an activity imposes on an unrelated third party. Similar to a negative externality, it can arise either on the production side, or on the consumption side. A positive production externality occurs when a firm's production increases the well-being of others but the firm is uncompensated by those others, while a positive consumption externality occurs when an individual's consumption benefits other but the individual is uncompensated by those others.


Positive production externalities

Examples of positive production externalities * A
beekeeper A beekeeper is a person who keeps honey bees. Beekeepers are also called honey farmers, apiarists, or less commonly, apiculturists (both from the Latin '' apis'', bee; cf. apiary). The term beekeeper refers to a person who keeps honey bees i ...
who keeps the
bees Bees are winged insects closely related to wasps and ants, known for their roles in pollination and, in the case of the best-known bee species, the western honey bee, for producing honey. Bees are a monophyletic lineage within the superfamil ...
for their
honey Honey is a sweet and viscous substance made by several bees, the best-known of which are honey bees. Honey is made and stored to nourish bee colonies. Bees produce honey by gathering and then refining the sugary secretions of plants (primar ...
. A side effect or externality associated with such activity is the
pollination Pollination is the transfer of pollen from an anther of a plant to the stigma of a plant, later enabling fertilisation and the production of seeds, most often by an animal or by wind. Pollinating agents can be animals such as insects, birds ...
of surrounding crops by the bees. The value generated by the pollination may be more important than the value of the harvested honey. * The corporate development of some
free software Free software or libre software is computer software distributed under terms that allow users to run the software for any purpose as well as to study, change, and distribute it and any adapted versions. Free software is a matter of liberty, no ...
(studied notably by
Jean Tirole Jean Tirole (born 9 August 1953) is a French professor of economics at Toulouse 1 Capitole University. He focuses on industrial organization, game theory, banking and finance, and economics and psychology. In 2014 he was awarded the Nobel Memori ...
and
Steven Weber Steven Robert Weber (born March 4, 1961) is an American actor and comedian. He is best known for his role as Brian Hackett on the television series ''Wings'' which aired from April 1990 to May 1997 on NBC, as Sam Blue in '' Once and Again'', and ...
) *
Research and development Research and development (R&D or R+D), known in Europe as research and technological development (RTD), is the set of innovative activities undertaken by corporations or governments in developing new services or products, and improving existi ...
, since much of the economic benefits of research aren't captured by the originating firm. * An industrial company providing first aid classes for employees to increase on the job safety. This may also save lives outside the factory. * Restored historic buildings may encourage more people to visit the area and patronize nearby businesses. * A foreign firm that demonstrates up-to-date technologies to local firms and improves their productivity. *
Public transport Public transport (also known as public transportation, public transit, mass transit, or simply transit) is a system of transport for passengers by group travel systems available for use by the general public unlike private transport, typical ...
can increase economic welfare by providing transit services to other economic activities, however the benefits of those other economic activities aren't felt by the operator, it can also decrease the negative externalities of increasing road patronage in the absence of a
congestion charge Congestion pricing or congestion charges is a system of surcharging users of public goods that are subject to congestion through excess demand, such as through higher peak charges for use of bus services, electricity, metros, railways, tele ...
.


Positive consumption externalities

Examples of positive consumption externalities include: * An individual who maintains an attractive house may confer benefits to neighbors in the form of increased
market values Market value or OMV (Open Market Valuation) is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with ''open market value'', ''fair value'' or ''fair market value'', although the ...
for their properties. This is an example of a pecuniary externality, because the positive spillover is accounted for in market prices. In this case, house prices in the neighborhood will increase to match the increased real estate value from maintaining their aesthetic. (such as by mowing the lawn, keeping the trash orderly, and getting the house painted) * Anything that reduces the rate of transmission of an infectious disease carries positive externalities. This includes vaccines, quarantine, tests and other diagnostic procedures. For airborne
infection An infection is the invasion of tissues by pathogens, their multiplication, and the reaction of host tissues to the infectious agent and the toxins they produce. An infectious disease, also known as a transmissible disease or communicable dise ...
s, it also includes masking. For waterborne diseases, it includes improved sewers and sanitation. (See ''
herd immunity Herd immunity (also called herd effect, community immunity, population immunity, or mass immunity) is a form of indirect protection that applies only to contagious diseases. It occurs when a sufficient percentage of a population has become imm ...
'') * Increased
education Education is a purposeful activity directed at achieving certain aims, such as transmitting knowledge or fostering skills and character traits. These aims may include the development of understanding, rationality, kindness, and honesty. Va ...
of individuals, as this can lead to broader society benefits in the form of greater economic
productivity Productivity is the efficiency of production of goods or services expressed by some measure. Measurements of productivity are often expressed as a ratio of an aggregate output to a single input or an aggregate input used in a production proces ...
, a lower
unemployment rate Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the referen ...
, greater household mobility and higher rates of
political participation Citizen Participation or Public Participation in social science refers to different mechanisms for the public to express opinions—and ideally exert influence—regarding political, economic, management or other social decisions. Participato ...
. * An individual buying a product that is interconnected in a network (e.g., a
smartphone A smartphone is a portable computer device that combines mobile telephone and computing functions into one unit. They are distinguished from feature phones by their stronger hardware capabilities and extensive mobile operating systems, whic ...
). This will increase the usefulness of such phones to other people who have a video cellphone. When each new user of a product increases the value of the same product owned by others, the phenomenon is called a network externality or a
network effect In economics, a network effect (also called network externality or demand-side economies of scale) is the phenomenon by which the value or utility a user derives from a good or service depends on the number of users of compatible products. Netw ...
. Network externalities often have " tipping points" where, suddenly, the product reaches general acceptance and near-universal usage. * In an area that does not have a
public In public relations and communication science, publics are groups of individual people, and the public (a.k.a. the general public) is the totality of such groupings. This is a different concept to the sociological concept of the ''Öffentlichkei ...
fire department A fire department (American English) or fire brigade (Commonwealth English), also known as a fire authority, fire district, fire and rescue, or fire service in some areas, is an organization that provides fire prevention and fire suppression se ...
, homeowners who purchase
private Private or privates may refer to: Music * " In Private", by Dusty Springfield from the 1990 album ''Reputation'' * Private (band), a Denmark-based band * "Private" (Ryōko Hirosue song), from the 1999 album ''Private'', written and also recorde ...
fire protection services provide a positive externality to neighboring properties, which are less at risk of the protected neighbor's fire spreading to their (unprotected) house. Collective solutions or
public policies Public policy is an institutionalized proposal or a group decision-making, decided set of elements like laws, regulations, guidelines, and actions to Problem solving, solve or address relevant and Social issue, real-world problems, guided by a co ...
are implemented to
regulate Regulate may refer to: * Regulation * '' Regulate...G Funk Era'', an album from rapper Warren G ** Regulate (song), title song from the album See also * * * Regulator (disambiguation) Regulator may refer to: Technology * Regulator (automati ...
activities with positive or negative externalities.


Positional

Positional externalities are also called
Pecuniary externalities A pecuniary externality occurs when the actions of an economic agent cause an increase or decrease in market prices. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young ...
. Pecuniary externalities are those which affect a third party's profit but not their ability to produce or consume. These externalities "occur when new purchases alter the relevant context within which an existing positional good is evaluated."
Robert H. Frank Robert Harris Frank (born January 2, 1945) is the Henrietta Johnson Louis Professor of Management and a professor of economics at the Samuel Curtis Johnson Graduate School of Management at Cornell University. He contributes to the "Economic View" ...
,
Are Positional Externalities Different from Other Externalities
? " (draft for presentation for ''Why Inequality Matters: Lessons for Policy from the Economics of Happiness'',
Brookings Institution The Brookings Institution, often stylized as simply Brookings, is an American research group founded in 1916. Located on Think Tank Row in Washington, D.C., the organization conducts research and education in the social sciences, primarily in ec ...
,
Washington, D.C. ) , image_skyline = , image_caption = Clockwise from top left: the Washington Monument and Lincoln Memorial on the National Mall, United States Capitol, Logan Circle, Jefferson Memorial, White House, Adams Morgan, ...
, June 4–5, 2003).
Robert H. Frank Robert Harris Frank (born January 2, 1945) is the Henrietta Johnson Louis Professor of Management and a professor of economics at the Samuel Curtis Johnson Graduate School of Management at Cornell University. He contributes to the "Economic View" ...
gives the following example: :if some job candidates begin wearing expensive custom-tailored suits, a side effect of their action is that other candidates become less likely to make favorable impressions on interviewers. From any individual job seeker's point of view, the best response might be to match the higher expenditures of others, lest her chances of landing the job fall. But this outcome may be inefficient since when all spend more, each candidate's probability of success remains unchanged. All may agree that some form of collective restraint on expenditure would be useful." Frank notes that treating positional externalities like other externalities might lead to "intrusive economic and social regulation." He argues, however, that less intrusive and more efficient means of "limiting the costs of
expenditure cascades Expenditure cascades is an economic term coined by researcher Robert H. Frank. It describes changes in purchasing and consumption behaviour which ripple through the levels of income in response to changes in income inequality. Example During the l ...
"—i.e., the hypothesized increase in spending of middle-income families beyond their means "because of indirect effects associated with increased spending by top earners"—exist; one such method is the
personal income tax An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed as the product of a tax rate times the taxable income. Ta ...
.


Inframarginal

The concept of inframarginal externalities was introduced by James Buchanan and Craig Stubblebine in 1962. Inframarginal externalities differ from other externalities in that there is no benefit or loss to the marginal consumer. At the relevant margin to the market, the externality does not affect the consumer and does not cause a market inefficiency. The externality only affects at the inframarginal range outside where the market clears. These types of externalities do not cause inefficient allocation of resources and do not require policy action.


Technological

Technological externalities directly affect a firm's production and therefore, indirectly influence an individual's consumption; and the overall impact of society; for example
Open-source software Open-source software (OSS) is computer software that is released under a license in which the copyright holder grants users the rights to use, study, change, and distribute the software and its source code to anyone and for any purpose. Op ...
or
free software Free software or libre software is computer software distributed under terms that allow users to run the software for any purpose as well as to study, change, and distribute it and any adapted versions. Free software is a matter of liberty, no ...
development by corporations.


Supply and demand diagram

The usual economic analysis of externalities can be illustrated using a standard
supply and demand In microeconomics, supply and demand is an economic model of price determination in a Market (economics), market. It postulates that, Ceteris paribus, holding all else equal, in a perfect competition, competitive market, the unit price for a ...
diagram if the externality can be valued in terms of
money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
. An extra supply or demand curve is added, as in the diagrams below. One of the curves is the ''private cost'' that consumers pay as individuals for additional quantities of the good, which in competitive markets, is the marginal private cost. The other curve is the ''true'' cost that society as a whole pays for production and consumption of increased production the good, or the marginal
social cost Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and the costs imposed on the consumers as a consequence of being exposed to the transaction for which they are not compensated or charged. In other w ...
. Similarly, there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as
effective demand In economics, effective demand (ED) in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not ...
in the market. What curve is added depends on the type of externality that is described, but not whether it is positive or negative. Whenever an externality arises on the production side, there will be two supply curves (private and social cost). However, if the externality arises on the consumption side, there will be two demand curves instead (private and social benefit). This distinction is essential when it comes to resolving inefficiencies that are caused by externalities.


External costs

The graph shows the effects of a negative externality. For example, the
steel industry Steel is an alloy made up of iron with added carbon to improve its strength and fracture resistance compared to other forms of iron. Many other elements may be present or added. Stainless steels that are corrosion- and oxidation-resistant ty ...
is assumed to be selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under
laissez-faire ''Laissez-faire'' ( ; from french: laissez faire , ) is an economic system in which transactions between private groups of people are free from any form of economic interventionism (such as subsidies) deriving from special interest groups. ...
). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of
air pollution Air pollution is the contamination of air due to the presence of substances in the atmosphere that are harmful to the health of humans and other living beings, or cause damage to the climate or to materials. There are many different types ...
and
water pollution Water pollution (or aquatic pollution) is the contamination of water bodies, usually as a result of human activities, so that it negatively affects its uses. Water bodies include lakes, rivers, oceans, aquifers, reservoirs and groundwater. Water ...
. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit ''equals'' individual benefit. If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, that is that production should be increased ''only'' as long as the marginal social benefit exceeds the marginal social cost. The result is that a
free market In economics, a free market is an economic system in which the prices of goods and services are determined by supply and demand expressed by sellers and buyers. Such markets, as modeled, operate without the intervention of government or any o ...
is ''
inefficient Efficiency is the often measurable ability to avoid wasting materials, energy, efforts, money, and time in doing something or in producing a desired result. In a more general sense, it is the ability to do things well, successfully, and without ...
'' since at the quantity Qp, the social benefit is less than the social cost, so society as a whole would be better off if the goods between Qp and Qs had not been produced. The problem is that people are buying and consuming ''too much'' steel. This discussion implies that negative externalities (such as pollution) are ''more than'' merely an ethical problem. The problem is one of the disjunctures between marginal private and social costs that are not solved by the free market. It is a problem of societal communication and coordination to balance costs and benefits. This also implies that pollution is not something solved by competitive markets. Some ''collective'' solution is needed, such as a court system to allow parties affected by the pollution to be compensated, government intervention banning or discouraging pollution, or economic incentives such as
green tax An environmental tax, ecotax (short for ecological taxation), or green tax is a tax levied on activities which are considered to be harmful to the environment and is intended to promote environmentally friendly activities via economic incentives. ...
es.


External benefits

The graph shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the vaccination is less than the marginal social or public benefit by the amount of the external benefit (for example, society as a whole is increasingly protected from smallpox by each vaccination, including those who refuse to participate). This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume there are no external costs, so that social cost ''equals'' individual cost. If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. This latter again reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market is ''
inefficient Efficiency is the often measurable ability to avoid wasting materials, energy, efforts, money, and time in doing something or in producing a desired result. In a more general sense, it is the ability to do things well, successfully, and without ...
'' since at the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be better off if more goods had been produced. The problem is that people are buying ''too few'' vaccinations. The issue of external benefits is related to that of
public goods In economics, a public good (also referred to as a social good or collective good)Oakland, W. H. (1987). Theory of public goods. In Handbook of public economics (Vol. 2, pp. 485-535). Elsevier. is a good that is both non-excludable and non-riva ...
, which are goods where it is difficult if not impossible to exclude people from benefits. The production of a public good has beneficial externalities for all, or almost all, of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefits and costs. This also implies that vaccination is not something solved by competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government does this, the good is called a
merit good The economics concept of a merit good, originated by Richard Musgrave (economist), Richard Musgrave (1957, 1959), is a Good (economics and accounting), commodity which is judged that an individual or society should have on the basis of some concept ...
. Examples include policies to accelerate the introduction of
electric vehicles An electric vehicle (EV) is a vehicle that uses one or more electric motors for propulsion. It can be powered by a collector system, with electricity from extravehicular sources, or it can be powered autonomously by a battery (sometimes cha ...
or promote
cycling Cycling, also, when on a two-wheeled bicycle, called bicycling or biking, is the use of cycles for transport, recreation, exercise or sport. People engaged in cycling are referred to as "cyclists", "bicyclists", or "bikers". Apart from two ...
, both of which benefit
public health Public health is "the science and art of preventing disease, prolonging life and promoting health through the organized efforts and informed choices of society, organizations, public and private, communities and individuals". Analyzing the det ...
.


Causes

Externalities often arise from poorly defined
property right The right to property, or the right to own property (cf. ownership) is often classified as a human right for natural persons regarding their possessions. A general recognition of a right to private property is found more rarely and is typically h ...
s. While property rights to some things, such as objects, land, and money can be easily defined and protected, air, water, and wild animals often flow freely across personal and political borders, making it much more difficult to assign ownership. This incentivizes agents to consume them without paying the full cost, leading to negative externalities. Positive externalities similarly accrue from poorly defined property rights. For example, a person who gets a flu vaccination cannot own part of the
herd immunity Herd immunity (also called herd effect, community immunity, population immunity, or mass immunity) is a form of indirect protection that applies only to contagious diseases. It occurs when a sufficient percentage of a population has become imm ...
this confers on society, so they may choose not to be vaccinated. Another common cause of externalities is the presence of
transaction cost In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike produ ...
s. Transaction costs are the cost of making an economic trade. These costs prevent economic agents from making exchanges they should be making. The costs of the transaction outweigh the benefit to the agent. When not all mutually beneficial exchanges occur in a market, that market is inefficient. Without transaction costs, agents could freely negotiate and internalize all externalities.


Possible solutions


Solutions in non-market economies

* In
planned economies A planned economy is a type of economic system where investment, production and the allocation of capital goods takes place according to economy-wide economic plans and production plans. A planned economy may use centralized, decentralized, part ...
, production is typically limited only to necessity, which would eliminate externalities created by overproduction. * The central planner can decide to create and allocate jobs in industries that work to mitigate externalities, rather than waiting for the market to create a demand for these jobs.


Solutions in market economies

There are several general types of solutions to the problem of externalities, including both public- and private-sector resolutions: *
Corporations A corporation is an organization—usually a group of people or a company—authorized by the state to act as a single entity (a legal entity recognized by private and public law "born out of statute"; a legal person in legal context) and r ...
or
partnerships A partnership is an arrangement where parties, known as business partners, agree to cooperate to advance their mutual interests. The partners in a partnership may be individuals, businesses, interest-based organizations, schools, governments o ...
will allow confidential sharing of information among members, reducing the positive externalities that would occur if the information were shared in an economy consisting only of individuals. *
Pigovian tax A Pigouvian tax (also spelled Pigovian tax) is a tax on any market activity that generates negative externalities (i.e., external costs incurred by the producer that are not included in the market price). The tax is normally set by the government ...
es or
subsidies A subsidy or government incentive is a form of financial aid or support extended to an economic sector (business, or individual) generally with the aim of promoting economic and social policy. Although commonly extended from the government, the ter ...
intended to redress economic injustices or imbalances. *
Regulation Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. For ...
to limit activity that might cause negative externalities *
Government provision In economics, a public good (also referred to as a social good or collective good)Oakland, W. H. (1987). Theory of public goods. In Handbook of public economics (Vol. 2, pp. 485-535). Elsevier. is a good that is both non-excludable and non-riva ...
of services with positive externalities *
Lawsuit - A lawsuit is a proceeding by a party or parties against another in the civil court of law. The archaic term "suit in law" is found in only a small number of laws still in effect today. The term "lawsuit" is used in reference to a civil actio ...
s to compensate affected parties for negative externalities * Voting to cause participants to internalize externalities subject to the conditions of the
efficient voter rule In the study of voter behavior, the efficient voter rule speaks to the desirability of voter-driven outcomes. It applies to situations involving Externality, negative externalities such as pollution and crime, and positive externalities such as educ ...
. *
Mediation Mediation is a structured, interactive process where an impartial third party neutral assists disputing parties in resolving conflict through the use of specialized communication and negotiation techniques. All participants in mediation are ...
or negotiation between those affected by externalities and those causing them A
Pigovian tax A Pigouvian tax (also spelled Pigovian tax) is a tax on any market activity that generates negative externalities (i.e., external costs incurred by the producer that are not included in the market price). The tax is normally set by the government ...
(also called Pigouvian tax, after economist Arthur C. Pigou) is a tax imposed that is equal in value to the negative externality. In order to fully correct the negative externality, the per unit tax should equal the marginal external cost. The result is that the market outcome would be reduced to the efficient amount. A side effect is that revenue is raised for the government, reducing the amount of distortionary taxes that the government must impose elsewhere. Governments justify the use of Pigovian taxes saying that these taxes help the market reach an efficient outcome because this tax bridges the gap between marginal social costs and marginal private costs. Some arguments against Pigovian taxes say that the tax does not account for all the transfers and regulations involved with an externality. In other words, the tax only considers the amount of externality produced. Another argument against the tax is that it does not take private property into consideration. Under the Pigovian system, one firm, for example, can be taxed more than another firm, even though the other firm is actually producing greater amounts of the negative externality. Further arguments against Pigou disagree with his assumption every externality has someone at fault or responsible for the damages. Coase argues that externalities are reciprocal in nature. Both parties must be present for an externality to exist. He uses the example of two neighbors. One neighbor possesses a fireplace, and often lights fires in his house without issue. Then one day, the other neighbor builds a wall that prevents the smoke from escaping and sends it back into the fire-building neighbor’s home. This illustrates the reciprocal nature of externalities. Without the wall, the smoke would not be a problem, but without the fire, the smoke would not exist to cause problems in the first place. Coase also takes issue with Pigou’s assumption of a “benevolent despot” government. Pigou assumes the government’s role is to see the external costs or benefits of a transaction and assign an appropriate tax or subsidy. Coase argues that the government faces costs and benefits just like any other economic agent, so other factors play into its decision-making. However, the most common type of solution is a tacit agreement through the political process. Governments are elected to represent citizens and to strike political compromises between various interests. Normally governments pass laws and regulations to address pollution and other types of environmental harm. These laws and regulations can take the form of "command and control" regulation (such as setting standards, targets, or
process requirements A process is a series or set of activities that interact to produce a result; it may occur once-only or be recurrent or periodic. Things called a process include: Business and management *Business process, activities that produce a specific se ...
), or
environmental pricing reform Environmental pricing reform (EPR) or Ecological fiscal reform (EFR) is a fiscal policy of adjusting market prices to account for environmental costs and benefits; this is accomplished by the utilization of any forms of taxation or subsidy to incen ...
(such as
ecotax An environmental tax, ecotax (short for ecological taxation), or green tax is a tax levied on activities which are considered to be harmful to the environment and is intended to promote environmentally friendly activities via economic incentives. ...
es or other Pigovian taxes, tradable pollution permits or the creation of markets for ecological services). The second type of resolution is a purely private agreement between the parties involved. Government intervention might not always be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically run communities can agree to deal with these costs and benefits in an amicable way. Externalities can sometimes be resolved by agreement between the parties involved. This resolution may even come about because of the threat of government action. The use of taxes and subsidies in solving the problem of externalities Correction tax, respectively subsidy, means essentially any mechanism that increases, respectively decreases, the costs (and thus price) associated with the activities of an individual or company. The private-sector may sometimes be able to drive society to the socially optimal resolution.
Ronald Coase Ronald Harry Coase (; 29 December 1910 – 2 September 2013) was a British economist and author. Coase received a bachelor of commerce degree (1932) and a PhD from the London School of Economics, where he was a member of the faculty until 1951. ...
argued that an efficient outcome can sometimes be reached without government intervention. Some take this argument further, and make the political argument that government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the
Coase theorem In law and economics, the Coase theorem () describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low trans ...
, requires that * Property rights be well-defined * People act rationally *
Transaction costs In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike produ ...
be minimal (costless bargaining) *
Complete information In economics and game theory, complete information is an economic situation or game in which knowledge about other market participants or players is available to all participants. The utility functions (including risk aversion), payoffs, strategies ...
If all of these conditions apply, the private parties can bargain to solve the problem of externalities. The second part of the
Coase theorem In law and economics, the Coase theorem () describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low trans ...
asserts that, when these conditions hold, whoever holds the property rights, a
Pareto efficient Pareto efficiency or Pareto optimality is a situation where no action or allocation is available that makes one individual better off without making another worse off. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engin ...
outcome will be reached through bargaining. This theorem would not apply to the steel industry case discussed above. For example, with a steel factory that trespasses on the lungs of a large number of individuals with pollution, it is difficult if not impossible for any one person to negotiate with the producer, and there are large transaction costs. Hence the most common approach may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable") while paying for the regulation and enforcement with
taxes A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or ...
. The case of the vaccinations would also not satisfy the requirements of the Coase theorem. Since the potential external beneficiaries of vaccination are the people themselves, the people would have to self-organize to pay each other to be vaccinated. But such an organization that involves the entire populace would be indistinguishable from government action. In some cases, the Coase theorem is relevant. For example, if a logger is planning to clear-cut a
forest A forest is an area of land dominated by trees. Hundreds of definitions of forest are used throughout the world, incorporating factors such as tree density, tree height, land use, legal standing, and ecological function. The United Nations' ...
in a way that has a negative impact on a nearby
resort A resort (North American English) is a self-contained commercial establishment that tries to provide most of a vacationer's wants, such as food, drink, swimming, lodging, sports, entertainment, and shopping, on the premises. The term ''resort ...
, the resort-owner and the logger could, in theory, get together to agree to a deal. For example, the resort-owner could pay the logger not to clear-cut – or could buy the forest. The most problematic situation, from Coase's perspective, occurs when the forest literally does not belong to anyone, or in any example in which there are not well-defined and enforceable property rights; the question of "who" owns the forest is not important, as any specific owner will have an interest in coming to an agreement with the resort owner (if such an agreement is mutually beneficial). However, the Coase theorem is difficult to implement because Coase does not offer a negotiation method. Moreover, Coasian solutions are unlikely to be reached due to the possibility of running into the
assignment problem The assignment problem is a fundamental combinatorial optimization problem. In its most general form, the problem is as follows: :The problem instance has a number of ''agents'' and a number of ''tasks''. Any agent can be assigned to perform any ta ...
, the
holdout problem In finance, a holdout problem occurs when a bond issuer is in default or nears default, and launches an exchange offer in an attempt to restructure debt held by existing bond holders. Such exchange offers typically require the consent of hold ...
, the
free-rider problem In the social sciences, the free-rider problem is a type of market failure that occurs when those who benefit from resources, public goods (such as public roads or public library), or services of a communal nature do not pay for them or under-p ...
, or
transaction cost In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike produ ...
s. Additionally, firms could potentially bribe each other since there is little to no government interaction under the Coase theorem. For example, if one oil firm has a high pollution rate and its neighboring firm is bothered by the pollution, then the latter firm may move depending on incentives. Thus, if the oil firm were to bribe the second firm, the first oil firm would suffer no negative consequences because the government would not know about the bribing. In a dynamic setup, Rosenkranz and Schmitz (2007) have shown that the impossibility to rule out Coasean bargaining tomorrow may actually justify Pigouvian intervention today. To see this, note that unrestrained bargaining in the future may lead to an underinvestment problem (the so-called
hold-up problem In economics, the hold-up problem is central to the theory of incomplete contracts, and shows the difficulty in writing complete contracts. A hold-up problem arises when two factors are present: #Parties to a future transaction must make noncon ...
). Specifically, when investments are relationship-specific and non-contractible, then insufficient investments will be made when it is anticipated that parts of the investments’ returns will go to the trading partner in future negotiations (see Hart and Moore, 1988). Hence, Pigouvian taxation can be welfare-improving precisely because Coasean bargaining will take place in the future. Antràs and Staiger (2012) make a related point in the context of international trade. Kenneth Arrow suggests another private solution to the externality problem. He believes setting up a market for the externality is the answer. For example, suppose a firm produces pollution that harms another firm. A competitive market for the right to pollute may allow for an efficient outcome. Firms could bid the price they are willing to pay for the amount they want to pollute, and then have the right to pollute that amount without penalty. This would allow firms to pollute at the amount where the marginal cost of polluting equals the marginal benefit of another unit of pollution, thus leading to efficiency. Frank Knight also argued against government intervention as the solution to externalities. He proposed that externalities could be internalized with privatization of the relevant markets. He uses the example of road congestion to make his point. Congestion could be solved through the taxation of public roads. Knight shows that government intervention is unnecessary if roads were privately owned instead. If roads were privately owned, their owners could set tolls that would reduce traffic and thus congestion to an efficient level. This argument forms the basis of the traffic equilibrium. This argument supposes that two points are connected by two different highways. One highway is in poor condition, but is wide enough to fit all traffic that desires to use it. The other is a much better road, but has limited capacity. Knight argues that, if a large number of vehicles operate between the two destinations and have freedom to choose between the routes, they will distribute themselves in proportions such that the cost per unit of transportation will be the same for every truck on both highways. This is true because as more trucks use the narrow road, congestion develops and as congestion increases it becomes equally profitable to use the poorer highway. This solves the externality issue without requiring any government tax or regulations.


Solutions to greenhouse gas emission externalities

The negative effect of carbon emissions and other
greenhouse gas A greenhouse gas (GHG or GhG) is a gas that Absorption (electromagnetic radiation), absorbs and Emission (electromagnetic radiation), emits radiant energy within the thermal infrared range, causing the greenhouse effect. The primary greenhouse ...
es produced in production exacerbate the numerous environmental and human impacts of anthropogenic climate change. These negative effects are not reflected in the cost of producing, nor in the market price of the final goods. There are many public and private solutions proposed to combat this externality


Emissions fee

An emissions fee, or
carbon tax A carbon tax is a tax levied on the carbon emissions required to produce goods and services. Carbon taxes are intended to make visible the "hidden" social costs of carbon emissions, which are otherwise felt only in indirect ways like more sev ...
, is a tax levied on each unit of pollution produced in the production of a good or service. The tax incentivised producers to either lower their production levels or to undertake abatement activities that reduce emissions by switching to cleaner technology or inputs.


Cap-and-trade systems

The cap-and-trade system enables the efficient level of pollution (determined by the government) to be achieved by setting a total quantity of emissions and issuing tradable permits to polluting firms, allowing them to pollute a certain share of the permissible level. Permits will be traded from firms that have low abatement costs to firms with higher abatement costs and therefore the system is both cost-effective and cost-efficient. The cap and trade system has some practical advantages over an emissions fee such as the fact that: 1. it reduces uncertainty about the ultimate pollution level. 2. If firms are profit maximizing, they will utilize cost-minimizing technology to attain the standard which is efficient for individual firms and provides incentives to the research and development market to innovate. 3. The market price of pollution rights would keep pace with the price level while the economy experiences inflation. The emissions fee and cap and trade systems are both incentive-based approaches to solving a negative externality problem. They provide polluters with market incentives by increasing the opportunity cost of polluting, thus forcing them to internalize the externality by making them take the marginal external damages of their production into account.


Command-and-control regulations

Command-and-control regulations act as an alternative to the incentive-based approach. They require a set quantity of pollution reduction and can take the form of either a technology standard or a performance standard. A technology standard requires pollution producing firms to use specified technology. While it may reduce the pollution, it is not cost-effective and stifles innovation by incentivising research and development for technology that would work better than the mandated one. Performance standards set emissions goals for each polluting firm. The free choice of the firm to determine how to reach the desired emissions level makes this option slightly more efficient than the technology standard, however, it is not as cost-effective as the cap-and-trade system since the burden of emissions reduction cannot be shifted to firms with lower abatement.


Scientific calculation of external costs

A 2020 scientific analysis of external climate costs of foods indicates that external greenhouse gas costs are typically highest for animal-based products – conventional and organic to about the same extent within that
ecosystem An ecosystem (or ecological system) consists of all the organisms and the physical environment with which they interact. These biotic and abiotic components are linked together through nutrient cycles and energy flows. Energy enters the syste ...
-subdomain – followed by conventional dairy products and lowest for
organic Organic may refer to: * Organic, of or relating to an organism, a living entity * Organic, of or relating to an anatomical organ Chemistry * Organic matter, matter that has come from a once-living organism, is capable of decay or is the product ...
plant-based foods and concludes that contemporary monetary evaluations are "inadequate" and that
policy Policy is a deliberate system of guidelines to guide decisions and achieve rational outcomes. A policy is a statement of intent and is implemented as a procedure or protocol. Policies are generally adopted by a governance body within an organ ...
-making that lead to reductions of these costs to be possible, appropriate and urgent. Available unde
CC BY 4.0


Criticism

Ecological economics criticizes the concept of externality because there is not enough system thinking and integration of different sciences in the concept. Ecological economics is founded upon the view that the neoclassical economics (NCE) assumption that environmental and community costs and benefits are mutually cancelling "externalities" is not warranted.
Joan Martinez Alier Joan Martinez Alier (born 1939, Barcelona, Spain) is a Catalan economist, Emeritus Professor of Economics and Economic History and researcher at ICTA at the Autonomous University of Barcelona. Biography Martinez Alier has a Lic. Economics, Univer ...
, for instance shows that the bulk of consumers are automatically excluded from having an impact upon the prices of commodities, as these consumers are future generations who have not been born yet. The assumptions behind future discounting, which assume that future goods will be cheaper than present goods, has been criticized by Fred Pearce and by the
Stern Report The Stern Review on the Economics of Climate Change is a 700-page report released for the Government of the United Kingdom on 30 October 2006 by economist Nicholas Stern, chair of the Grantham Research Institute on Climate Change and the Environm ...
(although the Stern report itself does employ discounting and has been criticized for this and other reasons by ecological economists such as Clive Spash). Concerning these externalities, some, like the eco-businessman
Paul Hawken Paul Gerard Hawken (born February 8, 1946) is an American environmentalist, entrepreneur, author, economist, and activist. Biography Hawken was born in San Mateo, California, and grew up in the San Francisco Bay Area, where his father worked at ...
, argue an orthodox economic line that the only reason why goods produced unsustainably are usually cheaper than goods produced sustainably is due to a hidden subsidy, paid by the non-monetized human environment, community or future generations. These arguments are developed further by Hawken, Amory and Hunter Lovins to promote their vision of an environmental capitalist utopia in '' Natural Capitalism: Creating the Next Industrial Revolution''. In contrast, ecological economists, like Joan Martinez-Alier, appeal to a different line of reasoning. Rather than assuming some (new) form of capitalism is the best way forward, an older ecological economic critique questions the very idea of internalizing externalities as providing some corrective to the current system. The work by
Karl William Kapp Karl William Kapp (October 27, 1910 – April 4, 1976) was a German-American economist and Professor of Economics at the City University of New York and later the University of Basel. Kapp's main contribution was the development of a theory of s ...
argues that the concept of "externality" is a misnomer. In fact the modern business enterprise operates on the basis of shifting costs onto others as normal practice to make profits.
Charles Eisenstein Charles Eisenstein (born 1967) is an American public speaker and author. His work covers a wide range of topics, including the history of human civilization, economics, spirituality, and the ecology movement. Key themes explored include anti-c ...
has argued that this method of privatising profits while socialising the costs through externalities, passing the costs to the community, to the natural environment or to future generations is inherently destructive. Social ecological economist Clive Spash argues that externality theory fallaciously assumes environmental and social problems are minor aberrations in an otherwise perfectly functioning efficient economic system. Internalizing the odd externality does nothing to address the structural systemic problem and fails to recognize the all pervasive nature of these supposed 'externalities'. This is precisely why heterodox economists argue for a heterodox theory of social costs to effectively prevent the problem through the precautionary principle.Berger, Sebastian (ed) (2015). ''The Heterodox Theory of Social Costs'' by K. William Kapp. London: Routledge.


See also

* * * * * * * *


References


Further reading

* Anderson, David A. (2019) ''Environmental Economics and Natural Resource Management 5e''

New York: Routledge. * Berger, Sebastian (2017) The Social Costs of Neoliberalism: Essays in the Economics of K. William Kapp. Nottingham: Spokesman. * Berger, Sebastian (ed) (2015) The Heterodox Theory of Social Costs - by K. William Kapp. London: Routledge. * * Johnson, Paul M
Definition
"A Glossary of Economic Terms" * * * * *
Jean-Jacques Laffont Jean-Jacques Marcel Laffont (April 13, 1947 – May 1, 2004) was a French economist specializing in public economics and information economics. Educated at the University of Toulouse and the Ecole Nationale de la Statistique et de l'Administration ...
(2008) Externalities. In: Palgrave Macmillan (eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan, London


External links


ExternE – European Union project to evaluate external costs

Econ 120 – Externalities
{{Authority control Environmental economics Market failure Welfare economics Public economics