Externality of Production

What is Externality of Production?

Externality of production is a popular term in economics that refers to the cost or benefit that accrues to an unknowing third party from the production of a good or service. Externalities often occur when the price of a good determined by the market forces of demand and supply does not reflect the impact of its production on social welfare. American economist Milton Friedman refers to externalities as “neighborhood effects” or “spillovers.”

Positive and Negative Externalities of Production

A positive externality refers to the economic benefit enjoyed by a third party not directly related to the economic transaction. Some examples of positive externalities of production are given below:

• Treatment for a contagious disease administered by a private hospital to a patient provides considerable benefit to the neighbors of the patient (i.e., herd immunity), who do not bear the cost of this benefit.
• The education imparted by a school to thousands of students enhances the skillset of the economy’s workforce and benefits society as a whole in numerous ways.
• Adoption of organic farming techniques by a farmer helps the environment and the health of those who consume the food and those that live nearby.
• When the developers of the World Wide Web made it available free of cost, he generated a huge positive externality.
• An industrial equipment manufacturer providing first aid training to its employees to increase job safety may enable them to save lives outside the factory as well.

A negative externality is the economic cost incurred by a third party not directly related to the economic transaction. Some examples of negative externalities of production are as follows:

• Extensive use of chemical fertilizers and pesticides in farming may cause health problems for many people.
• Deforestation in the Amazon rainforest by a furniture manufacturer harms the indigenous community, leads to a loss of carbon consuming forests and global warming, and upsets the ecosystem of the forest.
• Burning of coal in railway engines in the past deteriorated the air quality, and made many people sick.
• Release of industrial effluents into water bodies imposes a huge cost on society in multiple ways, such as toxins in seafood and loss of fish diversity.

Views of Economists on Production Externalities

English economist Arthur C. Pigou formally conceptualized the concept of production and consumption externalities in his book, “The Economics of Welfare.” in 1920.

He opined that industrialists, solely concerned with their private profits, seldom had any incentive to minimize the social cost of their actions. It led to a deadweight loss of social welfare. Citing the example of a factory built in a residential complex, he examined the external cost that is imposed on those living in the complex in the form of air and noise pollution, congestion, etc.

Similarly, the sale of alcohol while beneficial to its manufacturers led to an increased demand for healthcare and law and order in the economy. He proposed that a tax should be imposed on a good to meet these external costs, which came to be known as a Pigouvian tax.

Economic Implications of Externalities of Production

In welfare economics, social benefit is viewed as the sum of private benefit and external benefit. Due to the positive externalities, the social marginal cost of production is less than the private marginal cost. It leads to the under-production of the good or service as the external benefit accruing to society is not taken into account by the market-driven processes of price determination.

On the other hand, negative externalities cause the social cost of a good to exceed the private cost and lead to the overproduction of the good or service. Transactions that would’ve been beneficial to all parties involved do not take place.

Overcoming Externalities of Production

Often, property rights to natural resources, such as air, water, forests, animals, etc., cannot be defined properly, thus leading to the exploitation of the resources at the hands of profit-driven businesses and results in negative externalities.

The government can play a crucial role in promoting positive and preventing negative externalities. It can do so in several ways, some of which are listed below.

• Pigouvian taxes can be imposed on goods that impose a social cost on society.
• Subsidies can be given to boost the consumption of socially beneficial goods and services.
• The government may regulate the permissible amount of pollution by industries.
• Using the nudge theory, the government can incentivize businesses to adopt eco-friendly and socially conscious practices.

Related Readings

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Environmental, Social, and Governance (ESG)
• External Economies of Scale
• Corporate Social Responsibility (CSR)
• Sustainable Investing
• See all economics resources