What are Externalities?

When individuals create, consume, or invest, it can have a ripple effect on other people even when they aren’t directly involved in those transactions. When said actions have a major effect on third parties, economists refer to those effects as externalities. There can be positive or negative externalities.

Understanding Externalities

Both the production and consumption of goods can lead to externalities that have a negative or positive consequence. Additionally, externalities can affect a single individual and organization, or impact broader society despite not being directly related to the production or consumption of the goods or services.

There are two main types of externalities-positive and negative. Both can also fall into the consumption and production bucket. Consumption externalities happen when a consumer uses a good, product, or service and it has a positive or negative impact on third parties. Production externalities are when companies or an industrial operation produce things that have a negative or positive impact on third parties.

Positive Externalities

Not all externalities have detrimental effects on third parties. Positive externalities can have positive effects no private enterprises and society at large.

For example, a positive consumption externality could be someone choosing to ride a bike to work instead of driving a car as that helps the environment. This benefit isn’t factored into the price of a bike or the production cost, which makes it an externality. A positive production externality could be a company building a grocery store in a neighborhood that doesn’t have one. While their primary motivation may be profit, people in the neighborhood benefit from easier access to food and likely have to travel a shorter distance for it.

Negative Externalities

Negative externalities don’t have a good impact on third parties. A common example is pollution caused by businesses. A company may decide to mass produce items in the name of expansion. Likewise, they may swap out more environmentally-friendly materials for ones that are more toxic to the environment to cut costs. In both cases, it could have negative effects on society such as air pollution and contributing to the development of pollution-related health issues. This is an example of a negative production externality since the costs associated with this pollution are not factored into the price or cost of production.

From a consumption perspective, passive smoking could be a negative consumption externality because of the second hand smoke element.

Consequences of Externalities

Externalities often lead to private gain, but this can be detrimental to society or other groups of people. This is why people often lobby for government intervention to mitigate the likelihood of negative externalities. By taxing companies the government can (ideally) use the funds to mitigate the effects of negative production externalities.

Subsidies

Positive externalities are encouraged by governments through means of subsidies. The subsidies are put in place to support the production or consumption of goods and services that have a positive effect on society. For instance, governments may subsidize education or research because the information acquired could help empower members of society.

Taxation

To ensure there are consequences for negative externalities, the government can impose taxes. The goal is to get producers and consumers to pay the social cost for their actions. Taxes may also help deter companies from making choices that harm society. This is an attempt to ‘internalize’ the externality. For example, by taxing carbon output regulations can incentive companies to incorporate the costs of the externality into the costs of their products.

Regulations and Legislation

Another form of government intervention is imposing regulations or legislation. For example, no smoking rules may apply in public spaces like parks and fines can be imposed for those who don’t adhere. Fines for littering are another example of a regulation implemented to deter a negative consumption externality.

Negative externalities can have a negative economic and social impact, especially when resources that could go towards bettering society have to go towards rectifying the effects of negative externalities.