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What is an 'Externality'

An externality is a positive or negative consequence (of an economic activity) experienced by unrelated third parties. Pollution emitted by a factory that spoils the surrounding environment and affects the health of nearby residents is an example of a negative externality. The effect of a well-educated labor force on the productivity of a company is an example of a positive externality.

BREAKING DOWN 'Externality'

Externalities occur in an economy when the production or consumption of a specific good impacts a third party that is not directly related to the production or consumption. Externalities, such as pollution, are one of the main reasons why governments step in with increased regulations.

Almost all externalities are considered to be technical externalities. These types of 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 makes it so there is a difference between the gain or loss of private individuals and the aggregate gain or loss of the society as a whole. Oftentimes, the action of an individual or organization results in positive private gains but detracts from the overall economy. Many economists consider technical externalities to be market deficiencies. This is why people advocate for government intervention to curb negative externalities through taxation and regulation.

Positive and Negative Externalities

Most externalities are negative. Pollution, for example, is a well-known negative externality. A corporation may decide to cut costs and increase profits by implementing new operations that are more harmful for the environment. The corporation realizes costs in the form of expanding its operations but also generate 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 useful GPS tool. Positive externalities have public, or social, returns that are higher than the private returns.

How to Overcome Externalities: Possible Solutions

Several possible solutions exist to overcome the problems that arise from externalities. These can include those from both the public and private sectors

Taxes are one type of solution to overcome externalities. To help reduce the negative effects of certain externalities (like pollution), governments can impose a tax on the goods affecting them. The tax, called a Pigovian tax (named after economist Arthur C. Pigou), 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 by imposing this type of tax, it will reduce the market outcome of the externality to an amount that is considered efficient. 

Subsidies can also be put into place, which helps increase consumption of a positive externality. One example would be to subsidize orchards that plant fruit trees in order to correct the positive externalities they offer to beekeepers. 

Governments can also implement regulation to offset the effects of externalities, and is considered to be the most common kind of solution. As mentioned above, people often turn to governments to pass and enact legislation and regulation to curb the negative side of externalities. Several examples include environmental regulations or health-related legislation. 

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