Externality Externalities Cost External Costs Social Benefit

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An externality occurs in economics when a decision (e.g., to wear obnoxious perfume or to dress up in nice clothes) causes costs or benefits to individuals or groups other than the person making the decision. In other words, the decision-maker does not bear all of the costs or reap all of the gains from his or her action. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society. If the world around the person making the decision benefits more than he/she does (education, safety), then the good will be underconsumed by individual decision makers; if the costs to the world exceed the costs to the individual making the choice (pollution, crime) then the good will be overconsumed from society's point of view.

1 Implications

To most economists, the problem of an externality usually concerns the results of market activity. Economists see voluntary exchange as mutually beneficial to both parties in an exchange. On the other hand, either the consumption of a product (perfume, nice clothes) or its production may have external effects -- as in the diagram. Those who suffer from external costs do so involuntarily, while those who enjoy from external benefits do so for free. The left-hand-side of the diagram shows consumption externalities (such as those of perfume), while the right-hand-side shows production externalities (such as those produced by a perfume factory).

From the perspective of a social planner or welfare economics, this will result in an outcome that is not socially optimal. From the perspective of anybody affected by the externality, it is either a negative factor in their lives (as with the perfume) or a boon (as with the other's pretty clothes). In the first case, the person who is affected by the negative externality (air pollution) will likely see it as violating his or her freedom to breathe freely. It might even be seen as trespassing on their lungs, violating their property rights. Thus, an external cost can easily pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights. An external benefit, on the other hand, may increase the availability of choices for -- and thus the amount of freedom of -- the beneficiaries with no cost to them. They may thus resist the ending of such beneficial externalities along with any associated inefficiencies.

The value of the effects of the externality are likely not something that can be easily calculated in a technocratic way by economists or social planners, since they reflect the ethical views and preferences of the entire population. Instead, for countries believing in popular sovereignty, some sort of democratic method is needed to attach values to the external costs and benefits.

Sometimes, externalities are called " neighborhood effects " or "spillovers" but it should not be thought that all externalities are small, spilling over only in the "neighborhood." For example, some claim that the burning of hydrocarbons affects the entire "neighborhood" of the Earth, encouraging global warming.

2 Types of externalities

Examples of these kinds of externalities include:

Pollution by a firm in the course of its production which causes nuisance or harm to others. This is an example of a negative externality, external cost, or external diseconomy.

The harvesting by one fishing company in the open sea depletes the stock of available fish for the other companies. Over-fishing may result. This is an example of a common property resource, sometimes referred to as the Tragedy of the commons.

An individual planting an attractive garden in front of his house may benefit others living in the area. This is an example of a positive externality, beneficial externality, external benefit, or external economy.

An individual buying a picture-phone for the first time will increase the usefulness of such phones to people who might want to call him or her. This may lead to the general acceptance of these phones. This is an example of a network externality.

In contrast:

A property tycoon buying up a large number of houses in a town, causing prices to rise and therefore making other people who want to buy the houses worse off (perhaps by excluding them from the housing market), is not causing an externality, because the effect is through prices, and is considered part of the normal functioning of the market. Alternatively, these effects are sometimes called " pecuniary externalities ", with externalities as defined above called "technological externalities." This article considers only the latter.

Externalities are important in economics because they may lead to inefficiency (see Pareto efficiencyPareto efficiency or Pareto optimality is a central concept in game theory with broad applications in economics, engineering and the social sciences. A change that can make at least one individual better off, without making any other individual worse off). Because the producers of externalities do not have an incentive to take into account the effect of their actions on others, the outcome will be inefficient. There will be too much activity that causes negative externalities such as pollution, and not enough activity that creates positive externalities, relative to an optimal outcome. As noted, external costs also can imply political conflicts, rancorous lawsuits, and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle.

Many of the most important externalities in the economy are concerned with pollution and the environment. See the article on environmental economicsEnvironmental economics is a subfield of economics concerned with environmental issues (other usages of the term are not uncommon). In using standard methods of economics, it is distinguished from green economics which subsumes the nonstandard approaches for more discussion of externalities and how they may be addressed in the context of environmental issues.

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Home > Externality

1 Implications

2 Types of externalities

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