What is an externality?
An externality is a cost or benefit of an activity that falls on a third party who is not part of the market transaction, and that is not reflected in the price. Because the market ignores it, production or consumption is not at the socially best level; this is a form of market failure. The idea was developed by the economist A. C. Pigou.
Negative externalities
A negative externality imposes a cost on others. Examples: a factory discharging effluents into a river harms fishermen downstream; vehicle exhaust harms the health of pedestrians; loud music disturbs neighbours. Here the marginal social cost (MSC) exceeds the marginal private cost (MPC): MSC = MPC + marginal external cost (MEC). The firm considers only its private cost, so it over-produces the good and the environment suffers.
Positive externalities
A positive externality gives a benefit to others. Examples: a beekeeper's bees pollinate a neighbouring orchard; vaccination protects others from disease; education creates better citizens; planting trees improves air for the neighbourhood. The social benefit exceeds the private benefit, so the market under-produces such goods.
Impacts and remedies
Negative externalities lead to pollution, health costs, resource degradation and conflicts. Remedies include:
- Pigouvian tax on the polluting activity, equal to the external cost, so that the polluter pays (the polluter pays principle).
- Subsidies for activities with positive externalities, such as solar panels or vaccination.
- Regulation: emission standards and bans.
- Tradable permits (cap and trade).
- Bargaining: the Coase theorem says that if property rights are clear and bargaining costs are low, the parties can negotiate an efficient outcome themselves.
Key points
- Externality = effect on third parties not reflected in price.
- Negative externality → over-production; positive → under-production.
- MSC = MPC + MEC.
- Pigouvian tax and polluter pays principle internalise external costs.
Exam tips
- Ask "who bears the cost or gets the benefit without paying?" to spot an externality.
- In MSC sums, add the external cost to the private cost.