An externality, in economics, is a side effect caused to an outside party in a business deal. The externality may have a positive or a negative effect on that party but it must be resolved for the deal to go forward successfully. Private property rights are often at the heart of externalities.

A legal system that protects private property rights is often the most efficient at correctly distributing costs and benefits to all parties, as long as there is a measurable economic impact to each of them.

If those rights are not clear, market failure can occur. Market failure, in this case, means that a solution that meets the reasonable needs of all parties is not reached.

Property Rights Are a Bargaining Chip

An externality can occur whenever an economic activity, or planned activity, imposes a cost or benefit on another party. It is called a positive externality if the activity imposes a net benefit and a negative externality if it imposes a net cost.

Key Takeaways

  • In economics, externalities may be intentional or unintentional side effects of economic activity on outside parties.
  • The externalities may be positive or negative but require resolution for all parties to be treated fairly.
  • Private property rights may be seen as the chief bargaining tool of many of those affected by externalities.

In many if not most cases, the outside party's power to seek redress for a negative externality lies in property rights.

For example, say many of your neighbors decide to bike to work rather than drive.

Good and Bad Effects

Those bike-riding commuters create a net benefit by reducing the amount of traffic you have to deal with. They also reduce the air pollution in your immediate area and lower the demand, and therefore the price, of gasoline. You may even experience a reduced chance of being injured in an auto accident.

But suppose your neighbors ride their bicycles through your front yard and damage your landscaping. This is a clear-cut case of externalities negatively affecting your property rights.

The issue to be negotiated is the reassignment of those costs to the producer of the external effect rather than to you.

On a more serious scale, pollution is a classic negative externality. If you live next to a factory with a smokestack, you may experience net costs in the form of health complications, lower property value, and a dirty house. Your rights as a property owner allow you to seek a resolution to the issue.

Using Property Rights to Transfer Costs and Benefits

The simplest solution to externalities is to convince the recipient of external benefits or the producer of external costs to pay fairly for them.

In the absence of private property rights, there is no path to a solution that satisfies all parties.

Just as in a buyer-seller dynamic, the two parties can negotiate the market value of the external impact and come to an agreement. When they cannot agree, the producers of the problem may be forced to stop their cost-imposing activities until they come to terms.

An Example

The wildlands and trout streams of the United Kingdom are almost entirely privately owned. An industrial polluter who dirties the water or wildland is considered guilty of trespassing and creating property damage.

The wildland or stream owner can sue the polluter and get an injunction to stop the practice.

This effectively transfers the costs back to the polluter and away from the external party.

A Market Failure

When property rights are not clearly defined or adequately protected, market failure can occur. That is, no solution that meets the needs of all parties involved can be achieved.

Traffic congestion might be an example of an externality without a solution. Since no business owns the roads, there is no incentive to charge higher rates during peak times or discounts during nonpeak hours. The individual drivers on the roads have no distinct property rights. The result is an inefficient allocation of highway travel.

Pareto Optimality and Externalities

Among economists, discussions about externality often focus on the concept of the Pareto optimal solution, or Pareto efficiency. This theory states that it is sometimes impossible to arrive at a resolution that makes someone better off without also making someone else worse off.

Pareto optimality represents an ideal that is probably impossible. That is, that an exchange of goods or services could occur in which every single person who is directly or indirectly affected by it is perfectly satisfied.