Economics: Externalities

Definition of Externalities

• An externality is a consequence of an economic activity that affects third parties, either positively or negatively, who are not directly involved in the market transaction.
• Externalities can arise from both production and consumption activities.

Types of Externalities

• Positive externality: a beneficial effect on third parties, e.g.:
  • A beekeeper's bees pollinate neighboring crops, increasing their yield.
  • A homeowner's beautiful garden increases the value of neighboring properties.
• Negative externality: a harmful effect on third parties, e.g.:
  • A factory's pollution affects the health of nearby residents.
  • A farmer's use of pesticides contaminates the water supply.

Characteristics of Externalities

• Unpriced: externalities are not reflected in the market price of the good or service.
• Non-rivalrous: the consumption of the externality by one person does not reduce its availability to others.
• Non-excludable: it is difficult or impossible to exclude others from consuming the externality.

Effects of Externalities on Market Outcomes

• Overproduction: negative externalities can lead to overproduction, as the producer does not bear the full cost of the externality.
• Underproduction: positive externalities can lead to underproduction, as the producer does not capture the full benefit of the externality.

Correcting Externalities

• Government intervention: regulation, taxation, or subsidy can be used to internalize the externality.
• Private solutions: negotiation, contracting, or litigation between affected parties can also be used to internalize the externality.

Definition of Externalities

• An externality is a consequence of an economic activity that affects third parties, either positively or negatively, who are not directly involved in the market transaction.
• Externalities can arise from both production and consumption activities.

Types of Externalities

• Positive externality: a beneficial effect on third parties, e.g., beekeeper's bees pollinate neighboring crops, increasing their yield, and a homeowner's beautiful garden increases the value of neighboring properties.
• Negative externality: a harmful effect on third parties, e.g., a factory's pollution affects the health of nearby residents, and a farmer's use of pesticides contaminates the water supply.

Characteristics of Externalities

• Unpriced: externalities are not reflected in the market price of the good or service.
• Non-rivalrous: the consumption of the externality by one person does not reduce its availability to others.
• Non-excludable: it is difficult or impossible to exclude others from consuming the externality.

Effects of Externalities on Market Outcomes

• Overproduction: negative externalities can lead to overproduction, as the producer does not bear the full cost of the externality.
• Underproduction: positive externalities can lead to underproduction, as the producer does not capture the full benefit of the externality.

Correcting Externalities

• Government intervention: regulation, taxation, or subsidy can be used to internalize the externality.
• Private solutions: negotiation, contracting, or litigation between affected parties can also be used to internalize the externality.