7.2: Externalities in Depth

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Negative Externalities

Negative externalities are costs caused by an activity that affect an otherwise uninvolved party who did not choose to incur that cost.

Learning Objectives

Describe the impact of a negative externality on society

A negative externality is a cost that results from an activity or transaction and that affects an otherwise uninvolved party who did not choose to incur that cost.

Reasons for Negative Externalities

The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production. Production decisions are generally based on financial data and most social costs are not measured that way. For example, when a firm decides to open up a new factory, it will not account for the cost that residents accrue by drinking water from a river the factory polluted. As a result, a product that shouldn’t be produced, because the total expenses exceed the return, are made because social costs were not considered.

In other words, the costs of production represent individual, or private, marginal costs. The private marginal costs are lower than societal marginal costs, which also capture the true costs of the negative externalities. As a result, producers will overestimate the ideal quantity of the good to produce.

Negative Externality: Graphically, negative externalities occur when social costs are lower than private costs, and firms produce more units than is socially optimal. The ideal equilibrium quantity that reflects negative externalities is Qs, but firms may produce at Qp.

Government Solutions for Negative Externalities

In these cases, government intervention is necessary to help “price” negative externalities. Governments can either use regulation (e.g. outlaw an action) or use market solutions. By instituting policies such as pollution penalties, permitting civil lawsuits by private parties to recover damages for negligent actions, and levying environmental taxes, governments can achieve two things. First, these regulations recover funds to help fix the damage caused by negative externalities. Second, these acts help put a financial price on social costs. With that information, businesses can arrive at a more accurate figure for the costs of production. Businesses can then avoid producing products whose financial and social costs exceed the financial return.

Cigarette smoke: Secondhand smoke is an example of a negative externality; a person chooses to smoke, but others who do not choose to smoke are harmed.

Positive Externalities

Positive externalities are benefits caused by activities that affect an otherwise uninvolved party who did not choose to incur that benefit.

Learning Objectives

Use an example to discuss the concept of a positive externality

Positive externalities are benefits caused by transactions that affect an otherwise uninvolved party who did not choose to incur that benefit. Externalities occur all the time because economic events do not occur within a vacuum. Transactions often require the use of common resources that are shared with parties are not involved with the exchange. The use of these resources, in turn, impacts the uninvolved parties.

In the case of positive externalities, a transaction has positive side effects for non-related parties. Let’s take a look at some example:

A homeowner keeps his house maintained, the neighborhood benefits through higher home values. The homeowner’s neighbors benefit from a positive externality.
A person may keep bees for her own enjoyment, but gardeners in the area benefit because their flowers are pollinated. The beekeeper’s transaction of purchasing bees ends up positively affecting parties who are not involved in the transaction.
A person becomes inoculated against a disease, those around him benefit because they cannot catch the disease from him. There was an exchange between the doctor and the patient, but others also benefit.

In each of these cases, the people taking action are presumably not doing it for the sake of the community, but for their own purposes. The people taking the action may also enjoy the additional benefits described above, but initiators of actions are not considered beneficiaries of externalities.

The problem with positive externalities is that the people who create these advantages cannot charge the beneficiaries; the beneficiaries can “free ride,” or benefit without paying. For example, assume everyone in a community, except one person, got a flu shot. That one person could choose to abstain from receiving the shot; since everyone else got inoculated, he can’t get the disease from the others because they can’t catch the flu. That person would be a free rider since he would benefit from inoculations without incurring any cost.

Since parties that create the externality aren’t compensated, they do not have any incentive to create more. This results in a suboptimal result, because the producers of the externality will generally create less of the benefit than the larger community needs.

Key Points

The reason these negative externalities, otherwise known as social costs, occur is that these expenses are generally not included in calculating the costs of production.
Government intervention is necessary to help ” price ” negative externalities. They do this through regulations or by instituting market-based policies such as taxes, subsidies, or permit systems.
Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative externalities. As a result, firms may produce more units than is optimal from a societal standpoint.
Graphically, social costs will be lower than private costs because they do not take into account the additional costs of negative externalities. As a result, firms may produce more units than is optimal from a societal standpoint.
Externalities occur all the time because economic events do not occur within a vacuum. Transactions often require the use of common resources that are shared with parties are not involved with the exchange. The use of these resources in turn impacts the uninvolved parties.
The problem with positive externalities is that the people who create the externality cannot charge the beneficiaries; the beneficiaries can “free ride,” or benefit without paying.
Free riding results in a suboptimal result, because the producers of the externality will generally create less of the benefit than the larger community needs.

Key Terms

externality: An impact, positive or negative, on any party not involved in a given economic transaction or act.
free rider: One who obtains benefit from a public good without paying for it directly.

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