Externalities

Externalities are positive or negative effects on outsiders which spillover from economic activities of an individual or a firm and which are not properly priced by the market mechanism.

There are two types of externalities: positive and negative. Positive externalities refer to the benefits enjoyed by people outside the marketplace due to a firm’s actions but for which they do not pay any amount. On the other hand, negative externalities are the negative consequences faced by outsiders due a firm’s actions for which it is not charged anything by the market.

Externalities are a type of market failure, i.e. market’s inability to appropriately price all the consequences of economic actions. It arises because it is impossible or unfeasible to determine the price of the externality and/or no mechanism exists to collect it. Let’s consider a company who is authorized by government to build and operate an urban mass transit line in your city. The company pays for land it buys and incurs all the costs related to construction, but there is no way to compensate the residents who live nearby for the noise and discomfort they face due to construction activities. These represent negative externalities. However, once the mass transit line is operational, those who live nearby benefit the most not only from the decrease in travel time but through appreciation in the market value of their properties. These are the positive externalities. They result from diversion between private benefits and social benefits and between private costs and social costs of different economic activities.

Positive Externalities

Positive externalities cause the social benefits of an economic transaction (enjoyed both by private users who do pay a price for it and free-riders who do not pay anything) to exceed the private benefits that accrue to the market participants.

There are two types of positive externalities: (a) positive production externalities i.e. the positive unpriced benefits that arise from production process and (b) positive consumption externalities, i.e. the positive external benefits that arise from the consumption activities.

Examples of Positive Externalities

Following a few examples of positive externalities:

  • Appreciation in property values that result from construction of new roads, mass transit systems, etc. and travel time savings due to higher accessibility.
  • Development of new technologies by companies become freely available to other people after mandatory expiry of the patent.
  • Vaccination has an associated positive benefit for others because it reduces the risk of contraction.
  • Finding your location more accurately as your phone uses location of nearby Wi-Fi hot spots.

Negative Externalities

Negative externalities cause the social costs of an economic activity (those borne by the whole society) to exceed the private costs borne by the market participants.

There are two forms of negative externalities: (a) negative production externalities and (b) negative consumption externalities. Negative production externalities arise from production activities and negative consumption externalities are negative unpriced consequences of consumption process.

Let’s consider a manufacturing facility that generates air pollution. The following plot shows how a negative externality results in a market equilibrium which is less than optimal.

Negative Externalities

The intersection of the marginal private cost (MPC) and marginal private benefit (MPB) represent quantity Q1. It is the market equilibrium which exists without considering the associated negative externality. The air pollution causes significant health problems such that the marginal cost of the production is higher than its accounted-for cost. Therefore, the marginal social cost (MSC) curve is above the marginal private cost (MPC) curve. The intersection of the MPB and MSC represents Q1. This point shows the optimal price and quantity that should be produced to reflect the associate pollution costs. The shaded area represents the social losses that result from the negative externality. Luckily, the government can do something about this externality by restricting the firm’s ability to pollute the environment by requiring them to buy emission permits, the proceeds of which may be used to compensate for the health care and other costs that stem from air pollution.

The same framework used above to plot negative production externalities can be used to illustrate negative consumption externalities.

Examples of Negative Externalities

Following are a few examples of negative externalities:

  • The passive smoking endured by non-smokers when people smoke at public places.
  • The noise and vibration caused by trains to people who live nearby mass transit systems.
  • The decrease in stock of marine life due to excessive commercial fishing.
  • The effect of air, water and noise pollution and increase in travel time suffered by people due to traffic congestion in vicinity of large manufacturing facilities, airports, etc.

Written by Obaidullah Jan, ACA, CFA and last modified on