TheInfoList

In
economics Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of plant life and a bran ...

, an externality 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 presence of substances in the atmosphere that are harmful to the health of humans and other Outline of life forms, living beings, or cause damage to the climate or to materials. There are different types of air pollutants, ...

from
motor vehicle A motor vehicle, also known as motorized vehicle or automotive vehicle, is a self-propelled vehicle A vehicle (from la, vehiculum) is a machine that transports people or cargo. Vehicles include wagons, bicycles, motor vehicles (motorcycles ...
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. We 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 An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories and c ...
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 Pigovian tax (also spelled Pigouvian tax) is a tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law, a legal person is any person A person (plural people or ...

") 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 List of types of equilibrium, the condition of a system in which all competing influences are balanced, in a wide variety of contexts. Equilibrium may also refer to: Film and television * Equilibrium (film), ''Equilibrium'' (film), a 2002 scien ...
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 individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vi ...
. 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 presence of substances in the atmosphere that are harmful to the health of humans and other Outline of life forms, living beings, or cause damage to the climate or to materials. There are different types of air pollutants, ...

impose health and clean-up costs on the whole society, whereas the neighbors of individuals who choose to 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 s 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). s, the components of po ...

, 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 is involved. If there are external benefits, such as in
public safety Public security is the function of governments which ensures the protection of citizens, persons in their territory, organizations, and institutions against threats to their well-being – and to the prosperity of their communities. To meet the in ...
, 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 Utilitarianism is a family of normative ethical theories that prescribe actions that maximize happiness and well-being Well-being, also known as ''wellness'' ...

(1838–1900) is credited with first articulating, and
Arthur C. Pigou Arthur Cecil Pigou (; 18 November 1877 – 7 March 1959) was an English economist An economist is a professional and practitioner in the social science Social science is the branch The branches and leaves of a tree. A branch ( ...
(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). Indirect costs may be either fixed or variable. Indirect costs include administration, personnel and security ...
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. 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.

## Formal definition

Suppose that there are $K$ different possible allocations and $N$ different agents, where $K,N < \infty$ and $N \geq 2$. Suppose that each agent has a type and that each agent gets payoff $v_i\left(\theta_i, k\right) + t_i$, where $t_i$ is the transfer paid by the $i$-th agent. A map $f=\left(\kappa,t_1,\ldots,t_N\right)$ is a ''social choice function'' if :$\sum_^N t_i\left(\theta\right) \leq 0$ for all An allocation is ''ex-post efficient'' if :$\sum_^N v_i\left(\theta_i, \kappa\left(\theta\right)\right) \geq \sum_^N v_i\left(\theta_i, k\right)$ for all and all $k \in K.$ Let $\kappa^*$ denote an ex-post efficient allocation and let $\tilde_i$ denote an ex-post efficient allocation without agent $i$. Then the ''externality'' imposed by agent $i$ on the other agents is :$\sum_ v_j \left(\theta_j, \tilde_i \left(\theta_\right)\right) - \sum_ v_j \left(\theta_j, \kappa^* \left(\theta\right)\right),$ where $\theta_$ is the type vector $\theta$ without its $i$-th component. Intuitively, the first term is the hypothetical total payoff for all agents $j \neq i$ given that agent $i$ does not exist, and the second (subtracted) term is the actual total payoff for all agents $j \neq i$ given that agent $i$ does exist.

# Implications

The implications caused as a result of externalities can be both positive and negative. If two separate businesses agree to allow their activities to affect each other than it is mutually beneficial, because they would not agree to it in the first place if it was going to be damaging to their business. However, other external parties can also be affected by the deal without their knowledge or the other businesses' knowledge. Unlike the original transaction as the third party did not agree it could provide both positive and negative implications. A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected by the negative externalities in the case of air pollution will see it as lowered
utility As a topic of economics Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within thos ...

: 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 criminal law Criminal law is the body of law Law is a system A system is a group of Interaction, interacting or interrelated elements that act according to a set of rules to form a unified whole. A system, ...

on their
lung The lungs are the primary organs An organ is a group of tissues with similar functions. Plant life and animal life rely on many organs that co-exist in organ systems. A given organ's tissues can be broadly categorized as parenchyma ...

s, violating their property rights. 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 action (philosophy), behavior".''Internet Encyclopedia of Philosophy'"Ethics"/ref> The field of ethics, al ...
or
political Politics (from , ) is the set of activities that are associated with Decision-making, making decisions in Social group, groups, or other forms of Power (social and political), power relations between individuals, such as the distribution of res ...

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 An economic system, or economic order, is a system A system is a group of interacting Interaction is a kind of action that occurs as two or more objects hav ...
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, and philosopher who is best known for his defence of classical liberalism. Hayek shared the 1974 Nob ...
and
Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist An economist is a practitioner in the social sciences, social science discipline of economics. The individual may also study, develop, and apply theories and c ...

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 liberal ...

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 Professor (commonly abbreviated as Prof.) is an Academy, academic rank at university, universities and other post-secondary edu ...
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 Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and ser ...
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 presence of substances in the atmosphere that are harmful to the health of humans and other Outline of life forms, living beings, or cause damage to the climate or to materials. There are different types of air pollutants, ...

from burning fossil fuels. This activity causes damages to crops, materials and (historic) buildings and public health. *
Anthropogenic climate change Contemporary climate change includes both the global warming caused by humans, and its impacts on Earth's weather patterns. There have been previous periods of climate change, but the current changes are more rapid than any known event ...
as a consequence of
greenhouse gas emissions Greenhouse gas emissions from human activities strengthen the greenhouse effect The greenhouse effect is the process by which radiation from a planet's atmosphere warms the planet's surface to a temperature above what it would be without ...
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 The Government of the United Kingdom, domestically referred to as Her Majesty's Government, is the central governmen ...
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 indivi ...
we have ever seen." *
Water pollution Water pollution (or aquatic pollution) is the contamination of water bodies ( Lysefjord) in Norway Norway ( nb, ; nn, ; se, Norga; smj, Vuodna; sma, Nöörje), officially the Kingdom of Norway, is a Nordic countries, Nordic c ...

from industrial effluents can harm plants, animals, and humans * Spam emails during the sending of unsolicited messages by email. *
Noise pollution Noise pollution, also known as or sound , is the propagation of noise with ranging impacts on the activity of human or animal life, most of them harmful to a degree. The source of outdoor noise worldwide is mainly caused by machines, transport, ...
during the production process, which may be mentally and psychologically disruptive. *
Systemic risk In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money availab ...
: the risks to the overall economy arising from the risks that the banking system takes. A condition of
moral hazard#REDIRECT Moral hazard In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economi ...
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 Transparency (market), market transparency between banking institutions and the individuals and corpor ...
, 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 antibiotic Antibiotic misuse, sometimes called antibiotic abuse or antibiotic overuse, refers to the misuse or overuse of antibiotic An antibiotic is a type of antimicrobial substance active against bacteria Bacteria (; common noun bacteria, sin ...
s; 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 Fish are Aquatic animal, aquatic, craniate, gill-bearing animals that lack Limb (anatomy), limbs with Digit (anatomy), digits. Included in this definition are the living hagfish, lampreys, an ...
. This is an example of a common property resource, which is vulnerable to the
tragedy of the commons In economic science, the tragedy of the commons is a situation in which individual users, who have open access to a resource unhampered by shared social structures or formal rules that govern access and use, act independently according to their s ...
in the absence of appropriate environmental governance. * In the United States, the cost of storing
nuclear waste Radioactive waste is a type of that contains . Radioactive waste is a result of many activities, including , , generation, , and s reprocessing. The storage and disposal of radioactive waste is regulated by government agencies in order to protec ...
from
nuclear plant A nuclear power plant (sometimes abbreviated as NPP) is a thermal power station A thermal power station is a power station in which heat energy is converted to electricity. Typically, fuel is used to boil water in a large pressure vessel to ...

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 Yucca Mountain is a mountain in Nevada Nevada (, ) is a U.S. state, state in the Western United States, Western region of the United States. It is bordered by Oregon to the northwest, Idaho to the northeast, California to the west, Arizona t ...
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 or sound , is the propagation of noise with ranging impacts on the activity of human or animal life, most of them harmful to a degree. The source of outdoor noise worldwide is mainly caused by machines, transport, ...
: Sleep deprivation due to a neighbor listening to loud music late at night. *
Antibiotic resistance Antimicrobial resistance (AMR or AR) occurs when microbe A microorganism, or microbe,, ''mikros'', "small") and ''organism'' from the el, ὀργανισμός, ''organismós'', "organism"). It is usually written as a single word but is some ...

, 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 Pigovian tax (also spelled Pigouvian tax) is a tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law, a legal person is any person A person (plural people or ...
, and patents. *
Passive smoking Tobacco smoke in an smoking_ban.html"_;"title="Irish_pub_before_a_smoking_ban">Irish_pub_before_a_smoking_ban_came_into_effect_on_March_29,_2004 Passive_smoking_is_the_inhalation_of_smoke,_called_secondhand_smoke_(SHS),_or_environmental_tobacco ...
: 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#REDIRECT Moral hazard In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economi ...
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 characterised by slower speeds, longer trip times, and increased vehicular queueing Queue areas are places in which people queue ( first-come, first-served) for goods or services. Su ...

: 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" 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 indivi ...
or inefficiency, although they may still result in substantial harm to others.

## 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 , Germany A beekeeper is a person who keeps honey bees. Beekeepers are also called honey farmers, apiarists, or less commonly, apiculturists (both from the Latin ''Wiktionary:apis, apis'', bee; cf. apiary). The term beekeeper refers to a person ...

who keeps the
bees Bees are flying insects closely related to wasps and ants, known for their role in pollination and, in the case of the best-known bee species, the western honey bee, for producing honey. Bees are a monophyly, monophyletic lineage within the ...

for their
honey Honey is a sweet, viscous food substance made by honey bees Honey is a sweet, viscous food substance made by honey bees and some other Bee, bees. Bees produce honey from the sugary secretions of plants (floral nectar) or from secretion ...

. A side effect or externality associated with such activity is the
pollination Pollination is the transfer of pollen Pollen is a powdery substance consisting of pollen grains which are Sporophyte, microsporophytes of spermatophyta, seed plants, which produce male gametes (sperm cells). Pollen grains have a hard coat ...

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 ...

(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 psychological economics, economics and psychology. In 2014 he was aw ...

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, R+D), known in Europe Europe is a continent A continent is any of several large landmasses. Generally identified by convention (norm), convention rather than any strict criteria, up to seven geogra ...
, 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.

### 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 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) * An individual receiving a vaccination for a
communicable disease An infection is the invasion of an organism's body tissues by disease-causing agents, their multiplication, and the reaction of host tissues to the infectious agents and the toxins they produce. An infectious disease, also known as a transmi ...

not only decreases the likelihood of the individual's own infection, but also decreases the likelihood of others becoming infected through contact with the individual. (See ''
herd immunity Herd immunity (also called herd effect, community immunity, population immunity, or mass immunity) is a form of indirect protection from infectious disease An infection is the invasion of an organism's body Tissue (biology), tissues by Pa ...

'') * Increased
education Education is the process of facilitating learning, or the acquisition of knowledge, skills, value (ethics), values, morals, beliefs, habits, and personal development. Educational methods include teaching, training, storytelling, discussion ...

of individuals, as this can lead to broader society benefits in the form of greater economic
productivity Productivity is the efficiency 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 th ...
, a lower
unemployment rate Unemployment, according to the (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid or but currently available for work during the . Unemployment is measured by the unemplo ...
, 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. Particip ...
. * An individual buying a product that is interconnected in a network (e.g., a
smartphone A smartphone is a portable device A mobile device (or handheld computer) is a computer A computer is a machine that can be programmed to carry out sequences of arithmetic or logical operations automatically. Modern computers can per ...

). 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 Image:Metcalfe-Network-Effect.svg, Diagram illustrating the network effect in a few simple phone networks. The lines represent potential calls between phones. As the number of phones connected to the network grows, the number of potential calls avai ...

. 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 Public relations (PR) is the practice of managing and disseminating information from an individual or an organization An organization, or organisation (English in the Commonwealth of Nations, Commonwealth Engli ...
fire department A fire department (American English American English (AmE, AE, AmEng, USEng, en-US), sometimes called United States English or U.S. English, is the set of variety (linguistics), varieties of the English language native to the United Sta ...

, homeowners who purchase
private Private or privates may refer to: Music * "In Private "In Private" was the third single in a row to be a charting success for United Kingdom, British singer Dusty Springfield, after an absence of nearly two decades from the charts. Both "In Pri ...
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 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) * Regulation (disambiguation) {{Disambiguation ...

activities with positive or negative externalities.

## Positional

Positional externalities are also called Pecuniary externalities. These externalities "occur when new purchases alter the relevant context within which an existing positional good is evaluated." Robert H. Frank,
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 referred to simply as Brookings, is an American American(s) may refer to: * American, something of, from, or related to the United States of America, commonly known as the United States The United States ...
,
Washington, D.C. ) , image_skyline = , image_caption = Clockwise from top left: the Washington Monument The Washington Monument is an obelisk within the National Mall The National Mall is a Landscape architecture, landscaped ...
, June 4–5, 2003).
Robert H. Frank 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"—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 incomeTaxable income refers to the base upon which an income tax An income tax is a tax imposed on ...
.

## 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 Software is a collection of instructions Instruction or instructions may refer to: Computing * Instruction, one operation of a processor within a computer architecture instruction set * Co ...
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 ...

development by corporations.

# Supply and demand diagram

The usual economic analysis of externalities can be illustrated using a standard
supply and demand In microeconomics Microeconomics is a branch of that studies the behavior of individuals and in making decisions regarding the allocation of and the interactions among these individuals and firms. Microeconomics focuses on the study ...

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 main functions of money are distinguished as: a ...

. 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 Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are driven by the supply and demand In microeconomics, supply and ...
. 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 Economics () is a social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behavio ...
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 An alloy is an admixture of metal A metal (from Ancient Greek, Greek μέταλλον ''métallon'', "mine, quarry, metal") is a material that, when freshly prepared, polished, or fractured, shows a lustrous appe ...
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 An economic system, or economic order, is a system A system is a group of interacting Interaction is a kind of action that occurs as two or more objects hav ...
). 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 presence of substances in the atmosphere that are harmful to the health of humans and other Outline of life forms, living beings, or cause damage to the climate or to materials. There are different types of air pollutants, ...

and
water pollution Water pollution (or aquatic pollution) is the contamination of water bodies ( Lysefjord) in Norway Norway ( nb, ; nn, ; se, Norga; smj, Vuodna; sma, Nöörje), officially the Kingdom of Norway, is a Nordic countries, Nordic c ...

. 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 Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of pl ...
is '' inefficient'' 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 ecotax (short for ecological taxation) 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. Such a policy can complement or av ...
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'' 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 Economics () is a social science Social science is the branch A branch ( or , ) or tree branch (sometimes referred to in botany Botany, also called , plant biology or phytology, is the science of pla ...
, 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 goodThe concept of a merit good introduced in economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumptio ...
. Examples include policies to accelerate the introduction of
electric vehicles An electric vehicle (EV) is a vehicle that uses one or more traction motor, electric motors for propulsion. It can be powered by a Current collector, collector system, with electricity from extravehicular sources, or it can be powered autonomous ...
or promote
cycling Cycling, also called bicycling or biking, is the use of bicycles for transport, recreation, Physical exercise, exercise or sport. People engaged in cycling are referred to as "cyclists", "bicyclists", or "bikers". Apart from two-wheeled bic ...

, both of which benefit
public health Public health has been defined as "the science and art of preventing disease", prolonging life and improving quality of life Quality of life (QOL) is defined by the World Health Organization The World Health Organization (WHO) is a s ...

.

# Causes

Externalities often arise from poorly defined
property right The right to property or 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 heavily ...
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 from infectious disease An infection is the invasion of an organism's body Tissue (biology), tissues by Pa ...

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 (economics), market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companie ...
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 To invest is to allocate money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with th ...
, 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 A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal person, legal ...

or
partnerships A partnership is an arrangement where parties, known as business partnerA business partner is a commercial entity with which another commercial entity has some form of alliance. This relationship may be a contract A contract is a legally bin ...
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 Pigovian tax (also spelled Pigouvian tax) is a tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law Law is a system A system is a group of Interacti ...

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 A complex system is a system A system is a group of interacting Interaction is a kind of action that occurs as two or more objects have an effect upon one another. The idea of a two-way e ...

to limit activity that might cause negative externalities * Government provision of services with positive externalities *
Lawsuit A lawsuit is a proceeding by a party or parties against another in the civil Civil may refer to: *Civic virtue, or civility *Civil action, or lawsuit *Civil affairs *Civil and political rights *Civil disobedience *Civil engineering *Civil ...
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 negative externalities In economics Economics () is the social science that studies how peop ...
. *
Mediation Mediation is a structured, interactive process where an impartial third party assists disputing parties in resolving conflict through the use of specialized communication and negotiation techniques. All participants in mediation are encouraged ...

or negotiation between those affected by externalities and those causing them A
Pigovian tax A Pigovian tax (also spelled Pigouvian tax) is a tax A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity In law Law is a system A system is a group of Interacti ...

(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), or environmental pricing reform (such as ecotaxes or other Pigovian taxes, pollution market, 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 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, requires that * Property rights be well-defined * People act rationally * Transaction costs be minimal (costless bargaining) * Complete information If all of these conditions apply, the private parties can bargain to solve the problem of externalities. The second part of the Coase theorem asserts that, when these conditions hold, whoever holds the property rights, a Pareto efficient 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. 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 logging, logger is planning to clear-cut a forest in a way that has a negative impact on a nearby 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 holdout problem, the free-rider problem, or
transaction cost In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a Market (economics), market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companie ...

## Solutions to greenhouse gas emission externalities

The negative effect of carbon emissions and other Greenhouse gas, greenhouse gases 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, 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.

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 environmental impact of meat, highest for animal-based products – conventional and organic to about the same extent within that ecosystem-subdomain – followed by conventional dairy products and lowest for organic food, organic Plant-based diet#Sustainability, plant-based foods and concludes that contemporary monetary evaluations are "inadequate" and that policy-making that lead to Sustainable food system, 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, 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 (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, 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 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 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.

* * * * * * * *

# References

* 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 (2008) Externalities. In: Palgrave Macmillan (eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan, London