What is an Externality?

An externality is like your neighbors playing music at high volume...

If it’s keeping you up or you don’t enjoy it, that’s a negative externality. If it happens to be your favorite song and you feel like dancing, that’s a positive one.

An externality is something that meets all of the following criteria:

• It is a benefit or a cost
• The benefit or cost is generated by one person or group of people
• The person or group of people experiencing the benefit or cost is not involved in producing it

Externalities are important because they are part of the actual cost or value of an action, even though it sometimes can be difficult to quantify them. Externalities are not always unintentional side effects. Sometimes businesses know they are generating externalities, especially negative externalities. However, they ignore that fact out of convenience.

Externalities can be positive or negative. A positive externality will benefit the receiving party in some way, such as by reducing a cost they were already going to incur. A negative externality will harm the receiving party, such as by damaging their property.

Similarly, externalities can be production or consumption externalities. Production externalities are related to the production of a service or a good. For example, a factory that produces excessive noise while making goods. Consumption externalities arise when a service or good is consumed. For example, smoking a cigarette creates secondhand smoke.

An environmental externality is an externality that affects an ecosystem. Pollution is an example of a negative environmental externality that arises from many companies’ production processes. This can be in the form of air pollution, water pollution, or anything else that harms the environment.

Environmental externalities can also be related to the overuse of an ecological resource. For example, overfishing does not necessarily pollute an area, but it reduces or eliminates the population of fish in an area. This can impact the ecosystem of the area by knocking out part of its food chain and making it difficult to find fish in the future.

A company with a strong workforce training program can provide a positive externality to surrounding businesses in similar industries. For example, if a region is home to three plants that manufacture cars, and one plant provides excellent worker training, the other plants benefit from access to a well-trained labor pool. They do not influence the training practices of the third firm, but they benefit from it.

Another example of a positive externality is a neighborhood garden. The people that contribute to the garden plant seeds; they care for the plants. They get to benefit from the work that they’ve done by harvesting the things that grow. Meanwhile, the other residents of the neighborhood benefit from the pleasant view of the flowers and plants that grow.

Traffic in a city is an example of a negative externality. If too many people move to a city, its roads will become crowded, and traffic will be a common problem. This slows down travel and causes the city’s residents to incur higher costs for driving (such as longer commutes and increased vehicle maintenance). Each driver does not have control over the number of other drivers, but each driver is creating a negative externality for other drivers, in the form of increased traffic.

Another example of a negative externality is noise pollution. Whether it be a bar with a loud band or someone who is playing music without headphones on public transportation, the people who are within hearing range are experiencing the negative externality of being unable to listen to something of their choosing or to enjoy the quiet.

A market failure occurs when goods or services are not allocated efficiently, sometimes because the actual costs and benefits of a good or service are not accounted for properly.

Market failures relate to externalities because an externality can lead to an inability to value the real cost or benefit of something.

Consider the example of a company polluting a local river during its production of clothing. The company does not incur any costs from polluting the river. Instead, residents of the nearby area who cannot swim in the river, eat fish caught in the river, or drink from the river bear those costs. In an efficient market, the company polluting the river would bear the costs of pollution rather than ignoring them. When this cost is ignored by the company creating it, a market failure has occurred.

Similarly, a company that provides strong job training to its employees, which benefits competitors who hire those employees away, does not get the full value of its training program. Instead, some of that value is captured by its competitors. In an efficient market, the company providing the training would retain the value of its training program, and the competitors would have to pay for training programs of their own.

One of the primary causes of externalities is undefined or poorly defined property rights. When ownership over good is unclear, there is an incentive to consume as much of that good as possible. This is because the consumer will not incur the full cost of that consumption. Such a situation is known as the tragedy of the commons.

For example, it is all but impossible to define ownership over wild animals as they move across different areas without regard to property ownership. Hunters have the incentive to hunt as many animals as possible because there is no clear ownership over them. Because all hunters are similarly incentivized, it is easy for the animals in an area to be over-hunted, as each hunter seeks to maximize profit.

Correcting the effects of a negative externality is often a task for the government.

To overcome a negative externality, the party producing the externality must be made to bear more of the true cost of the externality they are producing. For example, a company that is polluting its region as a result of its production facilities should be made responsible for the costs of that pollution. This can be done with taxes on companies to make up for the negative externalities that they produce or direct intervention to make the company reduce its polluting. This kind of tax is known as a Pigovian tax, named after economist Arthur C. Pigou.

One example of this that has been proposed is carbon taxes. Under such a system, businesses would owe a tax based on the amount of carbon that they release into the atmosphere. By charging firms for the pollution that they create, the government would reduce market failures and force businesses to bear the true costs of their production.

Alternatively, the government could set limits on how much companies are allowed to pollute. This would incentivize them to reduce the negative externalities that they produce if they wish to continue to expand their production.