Externalities Quiz: Understand Negative and Positive Effects

Externalities in Economics: A Comprehensive Overview

Externalities are indirect costs or benefits to an uninvolved third party as a result of another party's activity.
Externalities can be negative (such as pollution) or positive (such as the enjoyment of smelling fresh pastries from an apartment above a bakery).
The concept of externality was first developed by economist Arthur Pigou in the 1920s.
Negative externalities can be reduced by imposing a tax (Pigouvian tax) equal to the marginal external cost, or by regulation.
Externalities cause market failure because the production or consumption of a product or service's private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole.
Positive externalities may appear to be beneficial, but they still represent a failure in the market as it results in the production of the good falling under what is optimal for the market.
The Free Rider Problem arises when people overuse a shared resource without doing their part to produce or pay for it, causing a failure in the market.
Negative externalities are more problematic than positive externalities because they are Pareto inefficient and undermine the whole idea of a market economy.
Positive externalities occur when an activity imposes a positive effect on an unrelated third party.
Technological externalities directly affect a firm's production and indirectly influence an individual's consumption and the overall impact of society.
Externalities can be illustrated using a standard supply and demand diagram, and whenever an externality arises on the production side, two supply curves are added, and if the externality arises on the consumption side, two demand curves are added.
Negative externalities can be reduced by implementing collective solutions or public policies to regulate activities with negative externalities.Solutions to Externalities
Externalities arise from poorly defined property rights, leading to negative externalities.
The market outcome is inefficient since people are buying too few vaccinations.
The government may step in with a collective solution, such as subsidizing or legally requiring vaccine use.
Pigovian tax is a tax imposed that is equal in value to the negative externality.
The private sector may sometimes be able to drive society to the socially optimal resolution.
The Coase theorem requires that transaction costs are low, property rights are well-defined, and a small number of parties are involved.
The most common approach may be to regulate the firm while paying for the regulation and enforcement with taxes.
An emissions fee or carbon tax is a tax levied on each unit of pollution produced in the production of a good or service.
The cap-and-trade system enables the efficient level of pollution to be achieved by setting a total quantity of emissions and issuing tradable permits to polluting firms.
Command-and-control regulations act as an alternative to the incentive-based approach.
Performance standards set emissions goals for each polluting firm.
A 2020 scientific analysis of external climate costs of foods indicates that external greenhouse gas costs are typically highest for animal-based products.Critiques of the Concept of Externality
Ecological economics criticizes the concept of externality for not having enough system thinking and integration of different sciences.
Ecological economics argues that environmental and community costs and benefits are not mutually cancelling "externalities."
The bulk of consumers are excluded from having an impact upon the prices of commodities, as these consumers are future generations who have not been born yet.
Future discounting, which assumes that future goods will be cheaper than present goods, has been criticized by ecological economists.
Unsustainable goods are cheaper than sustainable goods due to a hidden subsidy paid by the non-monetized human environment, community, or future generations.
Ecological economists question the idea of internalizing externalities as a corrective to the current system.
The concept of "externality" is a misnomer; the modern business enterprise operates on the basis of shifting costs onto others as normal practice.
Passing the costs to the community, to the natural environment, or to future generations is inherently destructive.
Externality theory fallaciously assumes environmental and social problems are minor aberrations in an otherwise perfectly functioning efficient economic system.
Heterodox economists argue for a heterodox theory of social costs to prevent the problem through the precautionary principle.