What’s it: Externalities are costs or benefits of economic activities borne by third parties who are not involved in it. They are not reflected in the final cost or benefit of the goods or services produced.
Economists view externalities as the cause of inefficient markets (market failures). Externalities are negative externalities and positive externalities. Negative means what raises costs, while positive provides benefits.
The cost of an externality is detrimental to others or the environment. It can take forms like radiation, river or air pollution, or noise. The surrounding community must suffer, and there is no compensation for that.
External benefits are the positive effects of economic activity on other parties who are uninvolved. For example, bee farmers benefit from nearby fruit farmers without paying for it (honey bees pick the nectar from fruit trees).
Types of externalities
Externalities often arise due to unclear enforcement of property rights. For some items such as land, buildings, and money, enforcing property rights is easy.
But, it isn’t for anything else like air and water. Water and air flow freely across private property boundaries. It makes it much harder to establish ownership.
In general, externalities fall into two groups:
- Negative externalities
- Positive externalities
Negative externalities represent the negative consequences of economic activity (consumption or production) to unrelated third parties. Some negative externalities are dangerous such as waste, pollution, and environmental pollution.
Well, I’m going to take a few examples of negative externality:
- Air pollution due to motor vehicle fumes or factories that use fossil fuels.
- Water pollution, for example, is due to oil tanker spills. This kind of pollution can destroy ecosystems in the ocean and affect people living in coastal areas.
- Noise pollution from aircraft harms people living near major airports.
- Smoking produces adverse effects not only for smokers but also for others’ health around smokers (second-hand smoke).
Positive externalities represent the benefits of economic activity for third parties who are not involved in it. While providing benefits, it also results in market inefficiencies.
The following are some examples of positive externalities, both related to production and consumption:
- Research and development. That benefits society, not only the company. Semiconductor research, for example, is not only beneficial for semiconductor manufacturers, but also the modern telecommunications, stereo, and computer equipment industries.
- Infrastructure development. The construction of roads and other transportation networks benefits the mobility of goods and people. Not only that, but real estate agents also get benefits. Real estate prices go up as construction makes accessibility better. Real estate agents earn higher commissions.
- Education and training. Improved education and training systems benefit not only workers and companies but also the economy as a whole. With better education and training, workers earn higher salaries, and companies can increase productivity. It also stimulates economic growth, decreases the unemployment rate, increases people’s incomes, cheaper and more varied goods, and reduces the crime rate.
- Vaccination. It benefits not only the vaccinated people but also others because the infection risk decreases.
Solutions to externalities
Policymakers propose several options to reduce externalities, especially negative externalities. They are:
- Enforcement of property rights
Property rights enforcement
A more stringent definition of property rights limits the effect of economic activity on unrelated parties. This is because many externalities arise due to unclear enforcement of property rights.
However, enforcing property rights is not an easy thing. Not all items can be clearly defined as the ownership, for example, water and air. Of course, you cannot divide the airspace for your home and for your neighbors.
Governments can tax goods or services to limit negative externalities, such as pollution and waste. The government imposes high tax sanctions on producers who dispose of hazardous waste. The government can also provide tax breaks for companies that process waste further, so it does not endanger the environment.
In this case, economists raise a Pigovian tax concept. The government should impose a tax as much as the impact of negative externalities. This tax type helps the market achieve optimal benefits because it bridges the gap between marginal social costs and marginal private costs.
Apart from taxes, another way for governments to limit externalities is through regulation. For example, the government can set maximum limits for carbon dioxide or waste pollution.
Regulation is considered the most common solution. You can find several rules, such as environmental regulations and health regulations for food and beverage.
The government can also provide subsidies to encourage certain activities. For example, the government provides subsidies to companies that use environmentally friendly fuels. Or, the government could subsidize education, enabling more people to attain a better education.