Externality
An externality is a cost or benefit that arises from the production or consumption of a good or service but falls on a third party who is not directly involved in the transaction. Because externalities are not reflected in market prices, they cause the market to produce an inefficient quantity of the good or service.[1]
Definition
An externality occurs when the actions of one party affect the well-being of another party without that effect being priced or compensated. Externalities may be negative or positive, and may arise from either production or consumption.[1]
Types
| Type | Description | Example |
|---|---|---|
| Negative production externality | A production cost borne by third parties. | Pollution from a factory. |
| Positive production externality | A production benefit enjoyed by third parties. | A firm's research benefiting other firms. |
| Negative consumption externality | A consumption cost borne by third parties. | Second-hand smoke from smoking. |
| Positive consumption externality | A consumption benefit enjoyed by third parties. | Immunisation reducing disease spread. |
Consequences
In the presence of a negative externality, the market produces too much of the good, because producers do not bear the full social cost. In the presence of a positive externality, the market produces too little, because producers do not capture the full social benefit. In both cases, the market outcome diverges from the socially efficient level.[1]
Remedies
Economists have proposed several approaches to internalise externalities:
- Pigouvian taxes and subsidies — taxes on activities generating negative externalities and subsidies for those generating positive externalities.
- Cap-and-trade and other market-based mechanisms.
- Direct regulation of the activity.
- Property rights and bargaining, as suggested by the Coase theorem, which shows that private parties can sometimes resolve externalities through negotiation if property rights are well defined and transaction costs are low.