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In economics, an externality is the cost or benefit that affects a third party who did not choose to incur that cost or benefit. 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 be a Pareto optimality.
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 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, 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, 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. For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed monetary value of benefits and costs to all parties involved.
History of the concept
Two British economists are credited with having initiated the formal study of externalities, or "spillover effects": Henry Sidgwick (1838–1900) is credited with first articulating, and Arthur C. Pigou (1877–1959) is credited with formalizing the concept of externalities.
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 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.
Suppose that there are different possible allocations and different agents, where and . Suppose that each agent has a type and that each agent gets payoff , where is the transfer paid by the -th agent. A map is a social choice function if
for all An allocation is ex-post efficient if
for all and all
Let denote an ex-post efficient allocation and let denote an ex-post efficient allocation without agent . Then the externality imposed by agent on the other agents is
where is the type vector without its -th component. Intuitively, the first term is the hypothetical total payoff for all agents given that agent does not exist, and the second (subtracted) term is the actual total payoff for all agents given that agent does exist.
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Voluntary exchange is by definition mutually beneficial to both business parties involved because the parties would not agree to undertake it if either thought it detrimental to their interests. However, a transaction can cause effects on third parties without their knowledge or consent. From the perspective of those affected, these effects may be negative (pollution from a nearby factory), or positive (honey bees kept for honey that also pollinate neighboring crops). Neoclassical welfare economics asserts that, under plausible conditions, the existence of externalities will result in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, whereas those who enjoy external benefits do so at no cost. 
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: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on their lungs, violating their property rights. Thus, an external cost may pose an ethical or political 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. 
Positive externalities, while Pareto efficient, are still market failures that undermine allocative efficiency because less of the good will be produced than would be optimal for society as a whole in a theoretical model with no government. If those externalities were internalized, the producer would be incentivized to produce more. Goods with positive externalities include education (believed to increase societal productivity and well-being, though some benefits are internalized in the form of higher wages), public health initiatives (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement.
Positive externalities are often associated with the free rider problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits (herd immunity); but any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.
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 economists such as Friedrich Hayek and Milton Friedman sometimes refer to externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized. Similarly, Ludwig von Mises argues that externalities arise from lack of "clear personal property definition."
|Negative||Negative externalities in consumption||Negative externalities in production|
|Positive||Positive externalities in consumption||Positive externalities in production|
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 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 also addresses externalities and how they may be addressed in the context of environmental issues.
"The corporation is an externalizing machine (moving its operating costs and risks to external organizations and people), in the same way that a shark is a killing machine." - Robert Monks (2003) Republican candidate for Senate from Maine and corporate governance adviser in the film "The Corporation".
Examples for negative production externalities include:
- Air pollution from burning fossil fuels. This activity causes damages to crops, materials and (historic) buildings and public health.
- Anthropogenic climate change as a consequence of greenhouse gas emissions from the burning of fossil fuels and the rearing of livestock. The Stern Review on the Economics of Climate Change says "Climate change presents a unique challenge for economics: it is the greatest example of market failure we have ever seen."
- Water pollution by industries that adds effluent, which harms plants, animals, and humans. Water usage from growing plants could impose a negative externality on citizens of counties or states who are harmed by decreased water.
- spam during the sending of unsolicited messages by email.
- Noise pollution during the production process, which may be mentally and psychologically disruptive.
- Systemic risk: the risks to the overall economy arising from the risks that the banking system takes. A condition of moral hazard can occur in the absence of well-designed banking regulation, 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. This is an example of a common property resource, which is vulnerable to the Tragedy of the commons in the absence of appropriate environmental governance.
- In the United States, the cost of storing nuclear waste from nuclear plants 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 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.
- Increased usage of antibiotics propagates increased antibiotic-resistant infections.
- The development of ill-health, notably early-onset Type II diabetes and metabolic syndrome, as a result of companies over processing foods - primarily the removal of fiber and the addition of sugars.
Examples of negative consumption externalities include:
- Noise pollution: Sleep deprivation due to a neighbor listening to loud music late at night.
- Antibiotic 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, and patents.
- Passive smoking: 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 hazards, 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: 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 consumer of goods in addition to their existing supply 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 or inefficiency, although they may still result in substantial harm to others.
- Second-hand smoke from cigarettes or marijuana: As cannabis legalization is considered, one potential negative consumption externality associated with legalization policy could be the second-hand smoke that could harm other's lungs, or second-hand highs.
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.
Examples of positive production externalities include:
- A beekeeper who keeps the bees for their honey. A side effect or externality associated with such activity is the pollination 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 (studied notably by Jean Tirole and Steven Weber )
- 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. Visitors enjoy visiting historic buildings. Preserving historic buildings provides an anchor to the past, as well as an incentive to the future.
- A foreign firm that demonstrates up-to-date technologies to local firms and improves their productivity.
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.
- An individual receiving a vaccination for a communicable disease 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)
- Increased education of individuals, as this can lead to broader society benefits in the form of greater economic productivity, a lower unemployment rate, greater household mobility and higher rates of political participation.
- An individual buying a product that is interconnected in a network (e.g., a smartphone). 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. 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 fire department, homeowners who purchase private 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.
The existence or management of externalities may give rise to political or legal conflicts.
- 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.
Inframarginal externalities are externalities in which there is no benefit or loss to the marginal consumer. In other words, people neither gain nor lose anything at the margin, but benefits and costs do exist for those consumers within the given inframarginal range.
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 or free software development by corporations.
Supply and demand diagram
The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be valued in terms of money. 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. 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 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.
The graph shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under laissez-faire). 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 and water pollution. 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 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 taxes.
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, 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. Examples include policies to accelerate the introduction of electric vehicles or promote cycling, both of which benefit public health.
Externalities often arise from poorly defined property rights. 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 this confers on society, so they may choose not to be vaccinated.
Solutions in non-market economies
- In a gift economy, people are expected to consume what they are given. If they consume a gift which they value less than somebody else, that other person who cannot consume it is harmed, an externality. A market system will reduce this kind of externality because the person who values it less is more likely to trade it away and the person who values it more is more likely to trade for it.
Solutions in market economies
There are several general types of solutions to the problem of externalities, including both public- and private-sector resolutions:
- Corporations or partnerships 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 taxes or subsidies intended to redress economic injustices or imbalances.
- Regulation to limit activity that might cause negative externalities
- Government provision of services with positive externalities
- Lawsuits to compensate affected parties for negative externalities
- Mediation or negotiation between those affected by externalities and those causing them
A Pigovian tax (also called Pigouvian tax, after economist Arthur C. Pigou) is a tax imposed that is equal in value to the negative externality. 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.
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, 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 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 claim 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 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 costs. 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). 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.
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 explains why 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.
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