Externality

In economics, an externality is a cost or benefit resulting from an economic transaction that is borne or received by parties not directly involved in the transaction.

An externality occurs when a decision causes costs or benefits to third party stakeholders, often, although not necessarily, from the use of a public good. For example, manufacturing that causes air pollution imposes costs on others when making use of public air. In other words, the participants in an economic transaction do not necessarily bear all of the costs or reap all of the benefits of the transaction. In a competitive market, this means too much or too little of the good may be produced and consumed in terms of overall cost or benefit to society, depending on incentives at the margin and strategic behavior.

When there are no significant externalities, the standard economic analysis is that the parties to the transaction benefit and the overall welfare of society is improved. If third parties benefit substantially, such as in areas of education or safety, the good may be under-provided (or under-consumed); if costs to the public exceed costs to the economic decision makers, such as in pollution, the good may be over-provided, in terms of overall benefit or cost to society. Here, overall benefit and cost to society are defined as the collective economic utility for society.

Implications

Economic theory considers any voluntary exchange to be mutually beneficial to both parties, for example a buyer and seller. Any exchange, however, can result in additional positive or negative effects on third parties. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost. The left side of the chart (at right) shows externalities associated with consumption (such as the air pollution caused by driving), while the right side shows production externalities (such as water pollution from a car factory).

From the perspective of a social planner or welfare economist, negative externalities result in an outcome that is not socially optimal. From the perspective of those affected, a negative externality is a problem (pollution from a factory), or a gain (honey bees that polinate the garden). In the first case, the person who is affected by the negative externality 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 trespassing on their lungs, 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).

An external benefit, on the other hand, may increase the utility of third parties at no cost to them, which could be called "free lunch". Since the collective utility of society is improved but the direct participants have no way of monetizing the benefit, less of the good will be produced or consumed than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase overall productivity and therefore well-being) and health care (which may reduce the health risks and costs for third parties). Positive externalities are frequently associated with the free rider problem. 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. In many cases, however, internalizing costs or benefits is not feasible or the true value cannot be determined.

The value of the effects of the externality are difficult to quantify because they reflect the ethical views and preferences of the entire population. It may not be clear whose preferences are most important, interests may conflict, the value of externalities may be difficult to determine, and all parties involved may attempt to influence the policy responses to their own benefit. Because it may not be feasible to monetize the costs and benefits, another method is needed to either impose solutions or aggregate the choices of society, when externalities are significant. This may be through some form of representative democracy or other means. Political economy is, in broad terms, the study of the means and results of aggregating those choices and benefits that are not limited to purely private transactions.

Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily minor or localized.

Outside the broadly-defined liberal political tradition, Marxists see externalities of all kinds, including pecuniary ones, as ubiquitous, being the rule rather than the exception. Production is socialized or totally interdependent. On the other hand, under capitalism, property rights, the appropriation of income, and the making of economic decisions are largely individualized. In order to solve this contradiction between socialized production and individual decision-making, Marxists often call for democratic economic planning, as a key part of socialism.(cf. Frederick Engels, "Socialism: Utopian and Scientific")

Externalities in supply and demand

The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be monetized and valued in terms of money. 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.

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 in the market.

Negative Externalities

Many negative externalities (external cost or external diseconomy) are related to the environmental consequences of production and use. The article on environmental economics also addresses externalities and how they may be addressed in the context of environmental issues.

Pollution of any form that causes nuisance or harm to others.

The harvesting by one fishing company in the ocean depletes the stock of available fish for the other companies and overfishing may result. This is an example of a common property resource, sometimes referred to as the Tragedy of the commons.

Individuals collectively choose to use a public transportation resource (such as roads), imposing congestion costs on all other users.

A business may purposely underfund one part of their business, such as their pension 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 hazards.

A property tycoon buying up a large number of houses in a town, causing prices to rise and therefore making other people who want to buy the houses worse off, perhaps by excluding them from the housing market. These effects are sometimes called "pecuniary externalities"; many economists do not accept the concept of pecuniary externalities, attributing such problems to anti-competitive behavior, monopoly power, or other definitions of market failures.

Accidents caused by alcohol abuse
Commonized costs of declining health and vitality caused by smoking and/or alcohol abuse

In these situations the marginal social benefit of consumption is less than the marginal private benefit of consumption. (i.e. SMB < PMB) This leads to the good or service being over-consumed relative to the social optimum. Without intervention the good or service will be under-priced and the negative externalities will not be taken into account.

Positive externalities

Examples of positive externalities (beneficial externality, external benefit, external economy, or Merit goods) include:

A beekeeper keeps the bees for their honey. A side effect or externality associated with his activity is the pollination 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 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.

An individual buying a picture-phone for the first time will increase the usefulness of such phones to people who might want to call him or her. 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 externalities often have "tipping points" where, quite suddenly, the product reaches general acceptance and near-universal usage.

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. Copyright and intellectual property law are mechanisms to allow the inventor or creator to benefit from a temporary, state-protected monopoly in return for "sharing" the information through publication or other means.

Education leads to a more civically-minded citizenry with a greater sense of altruism, and leads to a work force that can create more wealth.

Flu vaccinations of school children - the children themselves are unlikely to be greatly harmed by the flu, but vaccination of school children may often be the most efficient way to protect the vulnerable elderly.

Leisure of the old - once retired, the old help younger generations undertaking several activities such as babysitting children, paying bills and cleaning the son or daughter's house.

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 only charged people that had a fire, would arguably provide a positive externality at the expense of an unlucky few. Some form of insurance could be a solution in such cases, as long as people can accurately evaluate the benefit they have from the option.

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.

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.

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Supply & Demand with external benefits

If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price P_p and quantity Q_p as before, instead of the more efficient price P_s and quantity Q_s. 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 is inefficient since at the quantity Q_p, 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 pollution 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.

Positional Externalities

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.

An example of this would be working overtime at a job to look better than other employees. Because every employee wishes to look better than other employees, so as to get a raise or promotion, if one employee starts to work overtime then all employees must. And as each successive employee works more and more overtime, the externality gets larger and larger. No employee wants to work overtime, but each feels that he must in order to prevent being left behind.

Another example is the buying of jewelry for another person. In order for Person A to show that he values his spouse more than Person B values his spouse, Person A must buy his spouse more expensive jewelry than Person B buys. As in the first example, the cycle continues to get worse, because every actor positions himself/herself in relation to the other actors.

One solution to such externalities is regulations imposed by an outside authority. For the first example, the government might pass a law against working overtime. Thus every employee can go home and spend time at home with the family, what he/she really wants, and not worry about losing prestige at work.

Externalities and the Coase theorem

Ronald Coase argued that individuals could organize bargains so as to bring about an efficient outcome and eliminate externalities without government intervention. The 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," requires that

Property rights are well defined;
People act rationally
Transaction costs are minimal

If all three of these apply, individuals will bargain to solve the problem of externalities.

Thus, this theorem does 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 also does not fit with the Coase Theorem. The firms of the vaccination industry would have to get together to bribe large numbers of people to have their shots. Individual firms would be tempted to "free ride" and not pay the cost of these bribes. The property rights involved are not well defined.

This does not say that the Coase theorem is irrelevant. For example, if a logger is planning to clear-cut a forest in a way that has a negative impact on a nearby resort, the resort-owner and the logger could theoretically 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).

Also, the central government may not 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.