What Is an Externality?

An externality is an economic term referring to a cost or benefit incurred or received by a third party. However, the third party has no control over the creation of that cost or benefit.

An externality can be both positive or negative and can stem from either the production or consumption of a good or service. The costs and benefits can be both private—to an individual or an organization—or social, meaning it can affect society as a whole.

An externality may not affect the entity that causes the externality.

Pollution emitted by a factory that muddies the surrounding environment and affects the health of nearby residents is a negative externality. The effect of a well-educated labor force on the productivity of a company is an example of a positive externality.

Understanding Externalities

Externalities occur in an economy when the production or consumption of a specific good or service impacts a third party that is not directly related to the production or consumption of that good or service.

Almost all externalities are considered to be technical externalities. Technical externalities have an impact on the consumption and production opportunities of unrelated third parties, but the price of consumption does not include the externalities. This exclusion creates a gap between the gain or loss of private individuals and the aggregate gain or loss of society as a whole.

The action of an individual or organization often results in positive private gains but detracts from the overall economy. Many economists consider technical externalities to be market deficiencies, and this is the reason people advocate for government intervention to curb negative externalities through taxation and regulation.

Externalities were once the responsibility of local governments and those affected by them. So, for instance, municipalities were responsible for paying for the effects of pollution from a factory in the area while the residents were responsible for their healthcare costs as a result of the pollution. After the late 1990s, governments enacted legislation imposing the cost of externalities on the producer. This legislation increased costs, which many corporations passed on to the consumer making their goods and services more expensive.



Positive and Negative Externalities

Most externalities are negative. Pollution is a well-known negative externality. A corporation may decide to cut costs and increase profits by implementing new operations that are more harmful to the environment. The corporation realizes costs in the form of expanding operations but also generates returns that are higher than the costs.

However, the externality also increases the aggregate cost to the economy and society making it a negative externality. Externalities are negative when the social costs outweigh the private costs.

Some externalities are positive. Positive externalities occur when there is a positive gain on both the private level and social level. Research and development (R&D) conducted by a company can be a positive externality. R&D increases the private profits of a company but also has the added benefit of increasing the general level of knowledge within a society. So, while a company such as Google profits off of its Maps application, society as a whole greatly benefits in the form of a GPS tool. Positive externalities have public—or social—returns that are higher than the private returns.

Similarly, the emphasis on education is also a positive externality. Investment in education leads to a smarter and more intelligent workforce. Companies benefit from hiring employees who are educated because they are knowledgeable. This benefits employers because a better-educated workforce requires less investment in employee training and development costs.

Key Takeaways

  • An externality is a cost or benefit to a third party who has no control over how that cost or benefit was created.
  • Externalities can be both positive or negative and can come from producing or consuming a good or service.
  • Pollution is a common negative externality whose cost affects society as a whole.
  • Taxation is one way to overcome externalities.

Overcoming Externalities

There are solutions that exist to overcome the negative effects of externalities. These can include those from both the public and private sectors.

Taxes are one solution to overcoming externalities. To help reduce the negative effects of certain externalities such as pollution, governments can impose a tax on the goods causing the externalities. The tax, called a Pigovian tax—named after economist Arthur C. Pigou, sometimes called a Pigouvian tax—is considered to be equal to the value of the negative externality. This tax is meant to discourage activities that impose a net cost to an unrelated third party. That means that the imposition of this type of tax will reduce the market outcome of the externality to an amount that is considered efficient.

Subsidies can also overcome negative externalities by encouraging the consumption of a positive externality. One example would be to subsidize orchards that plant fruit trees to provide positive externalities to beekeepers.

Governments can also implement regulation to offset the effects of externalities. Regulation is considered the most common solution. The public often turns to governments to pass and enact legislation and regulation to curb the negative effects of externalities. Several examples include environmental regulations or health-related legislation.