- "In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's (or parties') activity."
Externalities are the costs or benefits of a market exchange that are not reflected in the prices of the goods and services involved in the exchange. Public economics examines how externalities can be internalized through policy interventions such as taxes and subsidies.
Definition of externality: An externality is an economic term for when the production or consumption of a good or service affects the well-being of someone who is not a producer or consumer.
Positive externality: Positive externality is a benefit that is enjoyed by a third-party as a result of an economic transaction, such as a vaccine that benefits not only the vaccinated person but also the community.
Negative externality: Negative externality is a cost that is imposed on third parties as a result of an economic transaction, such as air pollution from a factory that harms a nearby community.
Social Cost: Social cost refers to the total cost incurred by society, including private and external costs.
Private cost: Private cost is the cost that is borne by an individual or company involved in producing or consuming a good or service.
Marginal social cost: The marginal social cost is the cost imposed on society by producing an additional unit of a good or service.
Marginal private cost: The marginal private cost is the cost incurred by an individual or firm in producing an additional unit of a good or service.
Marginal external cost: The marginal external cost is the cost imposed on society by an additional unit of a good or service due to a negative externality.
Marginal social benefit: The marginal social benefit is the benefit that society receives from an additional unit of a good or service.
Marginal private benefit: The marginal private benefit is the benefit that an individual or firm receives from producing an additional unit of a good or service.
Marginal external benefit: The marginal external benefit is the benefit that a third-party receives from an additional unit of a good or service as a result of a positive externality.
Coase Theorem: The Coase Theorem suggests that in the presence of an externality, efficient outcomes can be reached through private bargaining and the assignment of property rights.
Pigouvian taxes: Pigouvian taxes are taxes on goods or services that have negative externalities, intending to make the producers or consumers of these goods and services pay for the damage caused.
Subsidies: Subsidies are payments made by the government to encourage the production or consumption of goods or services that have positive externalities.
Cap-and-trade schemes: Cap-and-trade schemes are market-based mechanisms that set a limit or cap on the total amount of pollution that can be emitted and allow companies to buy and sell permits that represent their right to pollute.
Common Property Resources: Common Property Resources are resources that are owned by more than one individual, such as fisheries or forests.
Tragedy of the Commons: The tragedy of the commons occurs when the shared resource is overused, depleted, or degraded because individuals act in their self-interest rather than considering the welfare of the group.
Public Goods: Public goods are goods or services that are non-excludable and non-rivalrous in consumption, such as national defense, lighthouses or public parks.
Free riders: Free riders are people who consume public goods or benefits from positive externalities without bearing any of the costs.
Private solutions to externalities: Private solutions to externalities include voluntary agreements, Coase bargaining, or property rights.
Positive externality: This occurs when the production or consumption of a good or service benefits a third party who did not pay for it. For example, a person who installs solar panels not only reduces their own electricity costs but also reduces air pollution, which benefits the community.
Negative externality: This occurs when the production or consumption of a good or service imposes costs on a third party who did not benefit from it. For example, a factory that pollutes a river negatively impacts the health and well-being of the downstream communities.
Technological externality: This refers to externalities arising from the use of a new technology, which impacts production, consumption or distribution of another good or service. For example, the introduction of electric cars creates positive technological externalities by lowering carbon emissions and cost of energy.
Knowledge externality: This occurs when the acquisition of knowledge or skills by one party benefits other parties, who may not have shared in the costs of obtaining the knowledge. For example, the discovery of a new medical treatment benefits not only the patient who received the treatment but also other patients who can now benefit from the same treatment.
Behavioral externality: This refers to externalities arising from the behavior of individuals or groups. For example, overeating and smoking can negatively impact public health, increasing healthcare costs borne by the society.
Network externality: This occurs when the value of a product or service increases as more people use it. For example, the value of social media platforms increases when more people join and use them, leading to a positive network externality.
Public good externality: This occurs when the production or consumption of a good or service benefits the whole community or society, leading to a positive externality. For example, public parks provide a good environment for relaxation for everyone, leading to a positive public good externality.
Merit/Badge externality: This refers to externalities associated with the status or prestige that comes with owning or consuming a product or service. For example, buying a luxury car can confer a badge of success or social status on the owner, leading to a merit externality.
Demerit externality: This refers to externalities arising from the negative perception or moral disapproval associated with the consumption or production of a particular good or service. For example, smoking or consuming alcohol can lead to moral disapproval, leading to a demerit externality.
Cultural externality: This occurs when cultural norms, beliefs or social conventions impact the production, consumption or distribution of a good or service. For example, the use of certain non-food items or products may be culturally or religiously prohibited, leading to a cultural externality.
- "Air pollution from motor vehicles is one example."
- "Water pollution from mills and factories is another example. All consumers are made worse off by pollution but are not compensated by the market for this damage."
- "A positive externality is when an individual's consumption in a market increases the well-being of others, but the individual does not charge the third party for the benefit."
- "An example of this might be the apartment above a bakery receiving the benefit of enjoyment from smelling fresh pastries every morning. The people who live in the apartment do not compensate the bakery for this benefit."
- "The concept of externality was first developed by economist Arthur Pigou in the 1920s."
- "Pigou argued that a tax, equal to the marginal damage or marginal external cost, (later called a 'Pigouvian tax') on negative externalities could be used to reduce their incidence to an efficient level."
- "Externalities are an example of market failure because 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."
- "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."
- "Once the externality is internalized through imposing a tax, the competitive equilibrium is now Pareto optimal."
- "However, since regulators do not always have all the information on the externality, it can be difficult to impose the right tax."
- "For example, manufacturing activities that cause air pollution impose health and clean-up costs on the whole society."
- "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."
- "Externalities can be considered as unpriced goods involved in either consumer or producer market transactions."
- "Air pollution from motor vehicles is one example."
- "Externalities cause the externality competitive equilibrium to not adhere to the condition of Pareto optimality."