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Externality

A cost or benefit of an economic activity experienced by an unrelated third party

What is an Externality?

An externality is a cost or benefit of an economic activity experienced by an unrelated third party. The external cost or benefit is not reflected in the final cost or benefit of a good or service. Therefore, economists generally view externalities as a serious problem that makes markets inefficient, leading to market failures. The externalities are the main catalysts that lead to the tragedy of the commons.

 

Externality

 

The primary cause of externalities is poorly defined property rights. The ambiguous ownership of certain things may create a situation when some market agents start to consume or produce more while the part of the cost or benefit is covered or received by an unrelated party. Environmental items, including air, water, and wildlife, is the most common example of things with poorly defined property rights.

 

Types of Externalities

Generally, externalities are categorized as either negative or positive.

 

1. Negative externality

A negative externality is a negative consequence of an economic activity experienced by an unrelated third party. The majority of externalities are negative. Some negative externalities such as the different kinds of environmental pollution are especially harmful due to their significant adverse effects. Negative externalities are divided into production and consumption externalities.

 

Examples of the negative production externalities include:

  • Air pollution: A factory burns fossil fuels to produce goods. The people living the nearby area and the workers of the factory suffer from the deteriorating air quality.
  • Water pollution: a tanker spills oil, destroying the wildlife in the sea and affecting the people living in coastal areas.
  • Noise pollution: People living near a large airport suffer from high noise levels.

 

Some examples of negative consumption externalities are:

  • Passive smoking: Smoking results in negative effects not only on the health of a smoker but on the health of other people.
  • Traffic congestion: The more people use roads, the heavier the traffic congestions are.

 

2. Positive externality

Positive externality is a benefit from an economic activity experienced by an unrelated third party. Despite the benefits of economic activities that involve positive externalities, the externality also creates market inefficiencies. Positive externalities can also be distinguished as production and consumption externalities.

 

Positive production externalities include:

  • Infrastructure development: Building a subway station in a remote neighborhood may benefit real estate agents who manage the properties in the area. Real estate prices would likely increase due to better accessibility, and the agents would be able to earn higher commissions.
  • R&D activities: A company that discovers a new technology as a result of the research and development (R&D) activities creates benefits that help the society as a whole.

 

Examples of positive consumption externalities are:

  • Individual education: The increased levels of an individual’s education can also raise economic productivity and reduce unemployment levels.
  • Vaccination: Benefits not only a person vaccinated but other people as well because of the probability of being infected decreases.

 

Solutions to Externalities

Due to the adverse effect of both negative and positive externalities on market efficiency, economists and policymakers intend to address the problem. The “internalization” of the externalities is the process of adopting policies that would limit the effect of the externalities on unrelated parties. Generally, the internalization is achieved through the government intervention. Possible solutions include the following:

 

1. Defining the property rights

The stricter definition of the property rights can limit the influence of economic activities on unrelated parties. However, it is not always a viable option since the ownership of particular things such as air or water cannot be unambiguously assigned to a particular agent.

 

2. Taxes

A government may impose taxes on goods or services that create externalities. The taxes would discourage activities that impose costs on unrelated parties.

 

3. Subsidies

A government can also provide subsidies to stimulate certain activities. The subsidies are commonly used to increase the consumption of goods with positive externalities.

 

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Invisible Hand
  • Network Effect
  • Normative Economics
  • Pareto Efficiency

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