Externality

Externality

Overview
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, an externality (or transaction spillover) is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit. The benefits of externalities, in this case, is called a positive externality or external benefit, while its cost is called a negative externality or external costs.

In these cases of both negative and positive externalities,in a competitive market, prices do not reflect the full costs or benefits of producing or consuming a product or service.
Also, producers and consumers may neither bear all of the costs nor reap all of the benefits of the economic activity, and too much or too little of the goods will be produced or consumed in terms of overall costs and benefits to society.
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Encyclopedia
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, an externality (or transaction spillover) is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit. The benefits of externalities, in this case, is called a positive externality or external benefit, while its cost is called a negative externality or external costs.

In these cases of both negative and positive externalities,in a competitive market, prices do not reflect the full costs or benefits of producing or consuming a product or service.
Also, producers and consumers may neither bear all of the costs nor reap all of the benefits of the economic activity, and too much or too little of the goods will be produced or consumed in terms of overall costs and benefits to society. For example, manufacturing that causes air pollution
Air pollution
Air pollution is the introduction of chemicals, particulate matter, or biological materials that cause harm or discomfort to humans or other living organisms, or cause damage to the natural environment or built environment, into the atmosphere....

 imposes costs on the whole society, while fire-proofing a home improves the fire safety
Fire safety
Fire safety refers to precautions that are taken to prevent or reduce the likelihood of a fire that may result in death, injury, or property damage, alert those in a structure to the presence of a fire in the event one occurs, better enable those threatened by a fire to survive, or to reduce the...

 of neighbors. If there exist external costs such as pollution
Pollution
Pollution is the introduction of contaminants into a natural environment that causes instability, disorder, harm or discomfort to the ecosystem i.e. physical systems or living organisms. Pollution can take the form of chemical substances or energy, such as noise, heat or light...

, the good will be overproduced by a competitive market, as the producer does not take into account the external costs when producing the good. If there are external benefits, such as in areas of education
Education
Education in its broadest, general sense is the means through which the aims and habits of a group of people lives on from one generation to the next. Generally, it occurs through any experience that has a formative effect on the way one thinks, feels, or acts...

 or public safety
Public Safety
Public safety involves the prevention of and protection from events that could endanger the safety of the general public from significant danger, injury/harm, or damage, such as crimes or disasters .-See also:* By nation...

, too little of the good would be produced by private markets as producers and buyers do not take into account the external benefits to others. Here, overall cost and benefit to society is defined as the sum of the economic benefits and costs for all parties involved.

Implications


Standard economic theory states that any voluntary exchange is mutually beneficial to both parties involved in the trade. This is because buyers or sellers would not trade if either thought it not beneficial to themselves. However, an exchange can cause additional effects on third parties. From the perspective of those affected, these effects may be negative (pollution from a factory), or positive (honey bees kept for honey that also pollinate crops). Welfare economics
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

 has shown that the existence of externalities results in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost.

A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected by the negative externalities in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass
Trespass
Trespass is an area of tort law broadly divided into three groups: trespass to the person, trespass to chattels and trespass to land.Trespass to the person, historically involved six separate trespasses: threats, assault, battery, wounding, mayhem, and maiming...

 on their lung
Lung
The lung is the essential respiration organ in many air-breathing animals, including most tetrapods, a few fish and a few snails. In mammals and the more complex life forms, the two lungs are located near the backbone on either side of the heart...

s, violating their property rights. Thus, an external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly defined property rights, as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries and/or legal traditions).

On the other hand, a positive externality would increase the utility of third parties at no cost to them. Since collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will be produced than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase societal productivity and well-being; but controversial, as these benefits may be internalized), public health initiatives (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement. Positive externalities are often associated with the free rider problem
Free rider problem
In economics, collective bargaining, psychology, and political science, a free rider is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding...

. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.

There are a number of potential means of improving overall social utility when externalities are involved. The market-driven approach to correcting externalities is to "internalize" third party costs and benefits, for example, by requiring a polluter to repair any damage caused. But, in many cases internalizing costs or benefits is not feasible, especially if the true monetary values cannot be determined.

.

Laissez-faire
Laissez-faire
In economics, laissez-faire describes an environment in which transactions between private parties are free from state intervention, including restrictive regulations, taxes, tariffs and enforced monopolies....

 economists such as Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...

 and Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

 sometimes refer to externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized. Simillarly, Ludwig Heinrich Edler von Mises argues that externalities arise from lack of "clear personal property defination".

Private and social costs: social costs are the spillover costs to society (society pays off the costs), while private costs are the costs given to the individual firms or producer.

Negative


A negative externality is an action of a product on consumers that imposes a negative side effect on a third party; it is "social cost".
Many negative externalities (also called "external costs" or "external diseconomies") are related to the environmental consequences of production and use. The article on environmental economics
Environmental economics
Environmental economics is a subfield of economics concerned with environmental issues. Quoting from the National Bureau of Economic Research Environmental Economics program:...

 also addresses externalities and how they may be addressed in the context of environmental issues.
  • Air pollution
    Air pollution
    Air pollution is the introduction of chemicals, particulate matter, or biological materials that cause harm or discomfort to humans or other living organisms, or cause damage to the natural environment or built environment, into the atmosphere....

     from burning fossil fuels causes damages to crops, (historic) buildings and public health. The most extensive and integrated effort to quantify and monetise these impacts was in the European ExternE project series.

  • Anthropogenic climate change is attributed to greenhouse gas
    Greenhouse gas
    A greenhouse gas is a gas in an atmosphere that absorbs and emits radiation within the thermal infrared range. This process is the fundamental cause of the greenhouse effect. The primary greenhouse gases in the Earth's atmosphere are water vapor, carbon dioxide, methane, nitrous oxide, and ozone...

     emissions from burning oil, gas, and coal. The Stern Review
    Stern Review
    The Stern Review on the Economics of Climate Change is a 700-page report released for the British government on 30 October 2006 by economist Nicholas Stern, chair of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and also chair of the Centre...

     on the Economics Of Climate Change
    says "Climate change presents a unique challenge for economics: it is the greatest example of market failure we have ever seen."

  • Water pollution by industries that adds poisons to the water, which harm plants, animals, and humans.

  • Systemic risk
    Systemic risk
    In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...

     describes the risks to the overall economy arising from the risks which the banking system takes. A condition of moral hazard
    Moral hazard
    In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

     can occur in the absence of well-designed banking regulation, or in the presence of badly designed regulation.

  • Industrial farm animal production
    Factory farming
    Factory farming is a term referring to the process of raising livestock in confinement at high stocking density, where a farm operates as a factory — a practice typical in industrial farming by agribusinesses. The main products of this industry are meat, milk and eggs for human consumption...

    , on the rise in the 20th century, resulted in farms that were easier to run, with fewer and often less-skilled employees, and a greater output of uniform animal products. However, the externalities with these farms include "contributing to the increase in the pool of antibiotic-resistant bacteria because of the overuse of antibiotics; air quality problems; the contamination of rivers, streams, and coastal waters with concentrated animal waste; animal welfare problems, mainly as a result of the extremely close quarters in which the animals are housed."

  • The harvesting by one fishing
    Fishing
    Fishing is the activity of trying to catch wild fish. Fish are normally caught in the wild. Techniques for catching fish include hand gathering, spearing, netting, angling and trapping....

     company in the ocean
    Ocean
    An ocean is a major body of saline water, and a principal component of the hydrosphere. Approximately 71% of the Earth's surface is covered by ocean, a continuous body of water that is customarily divided into several principal oceans and smaller seas.More than half of this area is over 3,000...

     depletes the stock of available fish for the other companies and overfishing
    Overfishing
    Overfishing occurs when fishing activities reduce fish stocks below an acceptable level. This can occur in any body of water from a pond to the oceans....

     may be the result. The stock fish is an example of a common property resource, and that, in the absence of appropriate environmental governance, is vulnerable to the Tragedy of the commons
    Tragedy of the commons
    The tragedy of the commons is a dilemma arising from the situation in which multiple individuals, acting independently and rationally consulting their own self-interest, will ultimately deplete a shared limited resource, even when it is clear that it is not in anyone's long-term interest for this...

    .

  • When car owners use roads, they impose congestion costs and higher accidents risks on all other users.

  • A business
    Business
    A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...

     may purposely underfund one part of their business, such as their pension
    Pension
    In general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...

     funds, in order to push the costs onto someone else, creating an externality. Here, the "cost" is that of providing minimum social welfare or retirement income; economists more frequently attribute this problem to the category of moral hazard
    Moral hazard
    In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

    s.

  • Consumption by one consumer causes prices to rise and therefore makes other consumers worse off, perhaps by reducing their consumption. These effects are sometimes called "pecuniary externalities" and are distinguished from "real externalities" or "technological externalities". Pecuniary externalities appear to be externalities, but occur within the market mechanism and are not a source of market failure
    Market failure
    Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...

     or inefficiency.

  • The consumption of alcohol when it leads to traffic or other accidents that injure or kill others.

  • Shared costs of declining health and vitality caused by smoking and/or alcohol abuse. Here, the "cost" is that of providing minimum social welfare. Economists more frequently attribute this problem to the category of moral hazard
    Moral hazard
    In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

    s, the prospect that a party insulated from risk may behave differently from the way they would if they were fully exposed to the risk. For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.

  • The cost of storing nuclear waste from nuclear plants for more than 1,000 years (over 100,000 for some types of nuclear waste) is included in the cost of the electricity the plant produces, in the form of a fee paid to the government and held in the Nuclear Waste Fund. Conversely, the costs of managing the long term risks of disposal of chemicals, which may remain permanently hazardous, is not commonly internalized in prices. The USEPA regulates chemicals for periods ranging from 100 years to a maximum of 10,000 years, without respect to potential long-term hazard.

  • Antibiotic overuse contributes to antimicrobial resistance, reducing the future effectiveness of antibiotics. Individuals do not consider this efficacy cost when making usage decisions, leading to socially sub-optimal antibiotic consumption. Government policies proposed to preserve future antibiotic effectiveness include educational campaigns, regulation, Pigouvian taxes, and patents.

  • There is evidence that crime in a neighborhood increases after the opening of a liquor store. Liquor stores may draw an undesirable class of citizens into the neighborhood to shop and hang out. They may also cause more people in the area to drink; such people may then proceed to commit acts in the neighborhood that they would not normally do, or else these drunk people may become easy targets for the crimes of others. Even if the crimes start out small, they may eventually become much worse if not effectively addressed (broken windows theory). Liquor stores are more likely to be open late into the night than other stores, and may result in increased noise levels which harm property values in the community.

Positive


Examples of positive externalities (beneficial externality, external benefit, external economy, or Merit good
Merit good
The concept of a merit good introduced in economics by Richard Musgrave is a commodity which is judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay...

s) include:
  • A beekeeper
    Beekeeper
    A beekeeper is a person who keeps honey bees for the purposes of securing commodities such as honey, beeswax, pollen, royal jelly; pollinating fruits and vegetables; raising queens and bees for sale to other farmers; and/or for purposes satisfying natural scientific curiosity...

     keeps the bees for their honey
    Honey
    Honey is a sweet food made by bees using nectar from flowers. The variety produced by honey bees is the one most commonly referred to and is the type of honey collected by beekeepers and consumed by humans...

    . A side effect or externality associated with his activity is the pollination
    Pollination
    Pollination is the process by which pollen is transferred in plants, thereby enabling fertilisation and sexual reproduction. Pollen grains transport the male gametes to where the female gamete are contained within the carpel; in gymnosperms the pollen is directly applied to the ovule itself...

     of surrounding crops by the bees. The value generated by the pollination may be more important than the value of the harvested honey.

  • An individual planting an attractive garden in front of his or her house may provide benefits to others living in the area, and even financial benefits in the form of increased property values for all property owners.

  • A public organization that coordinates the control of an infectious disease preventing others in society from getting sick.

  • An individual buying a product that is interconnected in a network (e.g., a video cellphone) will increase the usefulness of such phones to other people who have a video cellphone. When each new user of a product increases the value of the same product owned by others, the phenomenon is called a network externality or a network effect
    Network effect
    In economics and business, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it.The classic example is the telephone...

    . Network externalities often have "tipping points" where, suddenly, the product reaches general acceptance and near-universal usage.

  • Knowledge spillover
    Knowledge spillover
    Knowledge spillover is an exchange of ideas among individuals. In knowledge management economics, a knowledge spillover is a non-rival knowledge market externality that has a spillover effect of stimulating technological improvements in a neighbor through one's own innovation...

     of inventions and information - once an invention (or most other forms of practical information) is discovered or made more easily accessible, others benefit by exploiting the invention or information. Patent
    Patent
    A patent is a form of intellectual property. It consists of a set of exclusive rights granted by a sovereign state to an inventor or their assignee for a limited period of time in exchange for the public disclosure of an invention....

     law is a mechanism to allow the inventor or creator to benefit from a temporary, state-protected monopoly
    Monopoly
    A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...

     in return for "sharing" the information through publication or other means.

  • Sometimes the better part of a benefit from a good comes from having the option to buy something rather than actually having to buy it. A private fire department that charged only those people whose house fire they responded to, would arguably provide a positive externality to the entire community at the expense of an unlucky few who actually had to pay. Some form of insurance
    Insurance
    In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

     could be a solution in such cases, as long as people can accurately evaluate the benefit they have from the option.

    • The major downside to such a system is that the service provider has no obligation to provide the service. In 2010 in Tennessee, a home caught fire and the fire department refused to put the fire out because the household had failed to pay their fire fee of $75.00. In this instance, House A (Did not pay their fee) and the fire department refused to respond to quell the fire. After the fire spread to the neighbor’s home, the fire department responded and put House B’s (Paid the fee) fire out. House A eventually burned to the ground and House B incurred some fire damage but was generally still stable structurally etc. If the fee is not purchased, you will not receive the fire service. The optimal solution to this externality would be to instead charge a mandatory tax rather than an optional fee.

  • The sprinkler systems could eliminate the need for a fire department if it effectively eliminates the fire. “California and Pennsylvania, starting Jan. 1, 2011, will be the first two states in the country to require sprinklers in every new home based on the International Code Council (ICC) mandating the installation of residential fire sprinklers in all new one- and two-family residences, including townhouses in the 2009 International Residential Code (IRC). Other states, however, plan to adopt the residential fire sprinkler mandate but delay its implementation, while other states still oppose it.”(www.contractormag.com) This would have the potential to reduce the need of a large fire department in the long run. The argument could be made that the installation of a sprinkler system could pay for itself quickly, instead of having to pay a fire fee each year. Similarly, an “opt-in” policy of this nature would enable residents to pay the fire protection fee if they desired fire service, otherwise, they would not need to worry about being victimized by a neighbor’s “production” of fire damage (cost) to their home.

  • Some studies find that home ownership creates a positive externality in that homeowners are more likely than renters to become actively involved in the local community. A controlled study on the topic, however, disputes that this effect is causal. Still this is often a justification given for why, in the US, interest paid on a home mortgage is an available deduction from the income tax
    Itemized deduction
    An itemized deduction is an eligible expense that individual taxpayers in the United States can report on their federal income tax returns in order to decrease their taxable income....

    .

  • Education creates a positive externality because more highly educated people are less likely to engage in violent crime. This makes everyone in the community better off, regardless of their level of education.


As noted, externalities (or proposed solutions to externalities) may also imply political conflicts, rancorous lawsuits, and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle. Similarly, if too many positive externalities fall outside the participants in a transaction, there will be too little incentive on parties to participate in activities that lead to the positive externalities.

A common solution to providing positive externalities is taxation. A tax requires everyone to pay for a beneficial service, such as police
Police
The police is a personification of the state designated to put in practice the enforced law, protect property and reduce civil disorder in civilian matters. Their powers include the legitimized use of force...

 and fire protection
Fire protection
Fire protection is the study and practice of mitigating the unwanted effects of fires. It involves the study of the behaviour, compartmentalisation, suppression and investigation of fire and its related emergencies, as well as the research and development, production, testing and application of...

, which eliminates the free rider problem
Free rider problem
In economics, collective bargaining, psychology, and political science, a free rider is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding...

. A second way is an Individual mandate
Individual mandate
An individual mandate is a requirement by a government that certain individual citizens purchase or otherwise obtain a good or service.In the United States, the United States Congress has enacted two individual mandates, the first was never federally enforced, while the second is not scheduled to...

, a legal requirement that people purchase a beneficial product, such as insurance. In the United States, the 2010 Patient Protection and Affordable Care Act
Patient Protection and Affordable Care Act
The Patient Protection and Affordable Care Act is a United States federal statute signed into law by President Barack Obama on March 23, 2010. The law is the principal health care reform legislation of the 111th United States Congress...

 included a requirement that all citizens purchase health insurance to eliminate the free rider problem.

Positional


Positional externalities refer to a special type of externality that depends on the relative rankings of actors in a situation. Because every actor is attempting to "one up" other actors, the consequences are unintended and economically inefficient.

One example is the phenomenon of "over-education
Over-education
Anti-schooling activism or radical education reform seeks to abolish compulsory schooling laws.-Teaching as political control:A non-curriculum, non-instructional method of teaching was advocated by Neil Postman and Charles Weingartner in their book Teaching as a Subversive Activity...

" (referring to post-secondary education) in the North American labour market. In the 1960s, many young middle-class North Americans prepared for their careers by completing a bachelor's degree. However, by the 1990s, many people from the same social milieu were completing master's degrees, hoping to "one up" the other competitors in the job market by signalling
Signalling (economics)
In economics, more precisely in contract theory, signalling is the idea that one party credibly conveys some information about itself to another party...

 their higher quality as potential employees. By the 2000s, some jobs which had previously only demanded bachelor's degrees, such as policy analysis posts, were requiring master's degrees. Some economists argue that this increase in educational requirements was above that which was efficient, and that it was a misuse of the societal and personal resources that go into the completion of these master's degrees.

Another example is the buying of jewelry as a gift for another person, e.g. a spouse. For Husband A to show that he values Wife A more than Husband B values Wife B, Husband A must buy more expensive jewelry than Husband B. As in the first example, the cycle continues to get worse, because every actor positions him or herself in relation to the other actors. This is sometimes called keeping up with the Joneses
Keeping up with the Joneses
"Keeping up with the Joneses" is an idiom in many parts of the English-speaking world referring to the comparison to one's neighbor as a benchmark for social caste or the accumulation of material goods...

.

One solution to such externalities is regulations imposed by an outside authority. For the first example, the government might pass a law against firms requiring master's degrees unless the job actually required these advanced skills.

Supply and demand diagram


The usual economic analysis of externalities can be illustrated using a standard supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

 diagram if the externality can be valued in terms of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

. An extra supply or demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers pay as individuals for additional quantities of the good, which in competitive markets, is the marginal private cost. The other curve is the true cost that society as a whole pays for production and consumption of increased production the good, or the marginal social cost
Social cost
Social cost, in economics, is generally defined in opposition to "private cost". In economics, theorists model individual decision-making as measurement of costs and benefits...

.

Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demand
Effective demand
In economics, effective demand in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market...

 in the market.

External costs


The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under laissez-faire
Laissez-faire
In economics, laissez-faire describes an environment in which transactions between private parties are free from state intervention, including restrictive regulations, taxes, tariffs and enforced monopolies....

). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of air pollution
Air pollution
Air pollution is the introduction of chemicals, particulate matter, or biological materials that cause harm or discomfort to humans or other living organisms, or cause damage to the natural environment or built environment, into the atmosphere....

 and water pollution
Water pollution
Water pollution is the contamination of water bodies . Water pollution occurs when pollutants are discharged directly or indirectly into water bodies without adequate treatment to remove harmful compounds....

. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.

If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, that is that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result is that a free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

 is inefficient
Inefficiency
The term inefficiency has several meanings depending on the context in which its used:*Algorithmic inefficiency - refers to less than optimum computer programs that might exhibit one of more of the symptoms of:** slow execution...

since at the quantity Qp, the social benefit is less than the social cost, so society as a whole would be better off if the goods between Qp and Qs had not been produced. The problem is that people are buying and consuming too much steel.

This discussion implies that negative externalities (such as pollution) is more than merely an ethical problem. The problem is one of the disjuncture between marginal private and social costs that is not solved by the free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

. It is a problem of societal communication and coordination to balance costs and benefits. This also implies that pollution is not something solved by competitive markets. Some collective solution is needed, such as a court system to allow parties affected by the pollution to be compensated, government intervention banning or discouraging pollution, or economic incentives such as green taxes.

External benefits


The graph below shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the vaccination is less than the marginal social or public benefit by the amount of the external benefit (for example, society as a whole is increasingly protected from smallpox by each vaccination, including those who refuse to participate). This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume there are no external costs, so that social cost equals individual cost.

If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

 is inefficient
Inefficiency
The term inefficiency has several meanings depending on the context in which its used:*Algorithmic inefficiency - refers to less than optimum computer programs that might exhibit one of more of the symptoms of:** slow execution...

since at the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be better off if more goods had been produced. The problem is that people are buying too few vaccinations.

The issue of external benefits is related to that of public goods, which are goods where it is difficult if not impossible to exclude people from benefits. The production of a public good has beneficial externalities for all, or almost all, of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefits and costs. This also implies that vaccination is not something solved by competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government does this, the good is called a merit good
Merit good
The concept of a merit good introduced in economics by Richard Musgrave is a commodity which is judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay...

.

Possible solutions


There are at least four general types of solutions to the problem of externalities:
  • Criminalization: As with prostitution in some countries, drugs, commercial fraud, and many types of environmental and public health laws.
  • Civil Tort law: For example, class action by smokers, various product liability suits.
  • Government provision: As with lighthouses, education, and national defense.
  • Pigovian tax
    Pigovian tax
    A Pigovian tax is a tax levied on a market activity that generates negative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity...

    es or subsidies intended to redress economic injustices or imbalances.


A Pigovian tax is a tax imposed that is equal in value to the negative externality. The result is that the market outcome would be reduced to the efficient amount. A side effect is that revenue is raised for the government, reducing the amount of distortionary taxes that the government must impose elsewhere. Economists prefer Pigovian taxes and subsidies as being the least intrusive and most efficient method to resolve externalities.

However, the most common type of solution is tacit agreement through the political process. Governments are elected to represent citizens and to strike political compromises between various interests. Normally governments pass laws and regulations to address pollution and other types of environmental harm. These laws and regulations can take the form of "command and control" regulation (such as setting standards, targets, or process requirements), or environmental pricing reform
Environmental pricing reform
Environmental pricing reform is the process of adjusting market prices to include environmental costs and benefits.An externality exists where a market price omits environmental costs and/or benefits...

 (such as ecotax
Ecotax
Ecotax refers to taxes intended to promote ecologically sustainable activities via economic incentives. Such a policy can complement or avert the need for regulatory approaches. Often, an ecotax policy proposal may attempt to maintain overall tax revenue by proportionately reducing other taxes...

es or other pigovian tax
Pigovian tax
A Pigovian tax is a tax levied on a market activity that generates negative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity...

es, tradable pollution permits
Pollution market
A Pollution Market is a method of partly internalizing the costs a negative externality by setting up a government designated maximum amount of the specified activity and then auctioning or selling tradable permits to engage in some of the specified activity.For example, in a fictional state,...

 or the creation of markets for ecological services). The second type of resolution is a purely private agreement between the parties involved.

Government intervention may not always be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically-run communities can agree to deal with these costs and benefits in an amicable way. Externalities can sometimes be resolved by agreement between the parties involved. This resolution may even come about because of the threat of government action.

Ronald Coase
Ronald Coase
Ronald Harry Coase is a British-born, American-based economist and the Clifton R. Musser Professor Emeritus of Economics at the University of Chicago Law School. After studying with the University of London External Programme in 1927–29, Coase entered the London School of Economics, where he took...

 argued that if all parties involved can easily organize payments so as to pay each other for their actions, then an efficient outcome can be reached without government intervention. Some take this argument further, and make the political claim that government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the Coase Theorem
Coase theorem
In law and economics, the Coase theorem , attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are no transaction costs, bargaining will lead to...

, requires that
  • Property rights be well defined
  • People act rationally
  • Transaction costs be minimal

If all of these conditions apply, the private parties can bargain to solve the problem of externalities.

This theorem would not apply to the steel industry case discussed above. For example, with a steel factory that trespasses on the lungs of a large number of individuals with pollution, it is difficult if not impossible for any one person to negotiate with the producer, and there are large transaction costs. Hence the most common approach may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable") while paying for the regulation and enforcement with taxes. The case of the vaccinations would also not satisfy the requirements of the Coase Theorem. Since the potential external beneficiaries of vaccination are the people themselves, the people would have to self-organize to pay each other to be vaccinated. But such an organization that involves the entire populace would be indistinguishable from government action.

In some cases, the Coase theorem is relevant. For example, if a logger
Logging
Logging is the cutting, skidding, on-site processing, and loading of trees or logs onto trucks.In forestry, the term logging is sometimes used in a narrow sense concerning the logistics of moving wood from the stump to somewhere outside the forest, usually a sawmill or a lumber yard...

 is planning to clear-cut a forest
Forest
A forest, also referred to as a wood or the woods, is an area with a high density of trees. As with cities, depending where you are in the world, what is considered a forest may vary significantly in size and have various classification according to how and what of the forest is composed...

 in a way that has a negative impact on a nearby resort
Resort
A resort is a place used for relaxation or recreation, attracting visitors for holidays or vacations. Resorts are places, towns or sometimes commercial establishment operated by a single company....

, the resort-owner and the logger could, in theory, get together to agree to a deal. For example, the resort-owner could pay the logger not to clear-cut – or could buy the forest. The most problematic situation, from Coase's perspective, occurs when the forest literally does not belong to anyone; the question of "who" owns the forest is not important, as any specific owner will have an interest in coming to an agreement with the resort owner (if such an agreement is mutually beneficial).

See also


  • CC–PP game
  • Coase theorem
    Coase theorem
    In law and economics, the Coase theorem , attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are no transaction costs, bargaining will lead to...


  • Distortions (economics)
    Distortions (economics)
    A distortion is a condition that creates economic inefficiency, thus interfering with economic agents maximizing "social welfare" when they maximize their own welfare....

  • Free Rider Problem
    Free rider problem
    In economics, collective bargaining, psychology, and political science, a free rider is someone who consumes a resource without paying for it, or pays less than the full cost. The free rider problem is the question of how to limit free riding...


  • Greenhouse gas
    Greenhouse gas
    A greenhouse gas is a gas in an atmosphere that absorbs and emits radiation within the thermal infrared range. This process is the fundamental cause of the greenhouse effect. The primary greenhouse gases in the Earth's atmosphere are water vapor, carbon dioxide, methane, nitrous oxide, and ozone...

  • Market failure
    Market failure
    Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...


  • Pigovian tax
    Pigovian tax
    A Pigovian tax is a tax levied on a market activity that generates negative externalities. The tax is intended to correct the market outcome. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity...

  • Public good
    Public good
    In economics, a public good is a good that is non-rival and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability means that no one can be effectively excluded from using the good...


  • Social costs
  • Tragedy of the commons
    Tragedy of the commons
    The tragedy of the commons is a dilemma arising from the situation in which multiple individuals, acting independently and rationally consulting their own self-interest, will ultimately deplete a shared limited resource, even when it is clear that it is not in anyone's long-term interest for this...



External links