Externality

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An externality occurs in economics when a decision (e.g., to wear obnoxious perfume or to dress up in nice clothes) causes costs or benefits to individuals or groups other than the person making the decision. In other words, the decision-maker does not bear all of the costs or reap all of the gains from his or her action.

From the perspective of a social planner, this will result in an outcome that is not socially optimal. (See welfare economics.) From the perspective of anybody affected by the externality, it is either a negative factor in their lives (as with the perfume) or a boon (as with the other's pretty clothes). In the first case, the person who is affected by the negative externality (air pollution) will likely see it as violating his or her freedom to breathe freely. It might even be seen as trespassing on their lungs. Thus, an external cost can easily pose an ethical or political problem. The value of the effects of the externality are likely not something that can be easily calculated in a technocratic way by economists or social planners, since they reflect the ethical views and preferences of the entire population. Instead, for countries believing in popular sovereignty, some sort of democratic method is needed to attach values to the external costs and benefits.

Sometimes, externalities are called "neighborhood effects" or "spillovers" but it should not be thought that all externalities are small, spilling over only in the "neighborhood." For example, the burning of hydrocarbons likely affects the entire neighborhood of the Earth, encouraging global warming.

Examples of these kinds of externalities include:

Pollution by a firm in the course of its production which causes nuisance or harm to others. This is an example of a negative externality, external cost, or external diseconomy.
The harvesting by one fishing company in the open sea depletes the stock of available fish for the other companies. Over-fishing may result. This is an example of a common property resource.
An individual planting an attractive garden in front of his house may benefit others living in the area. This is an example of a positive externality, beneficial externality, external benefit, or external economy.
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. This may lead to the general acceptance of these phones. This is an example of a network externality.

In contrast:

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), is not causing an externality, because the effect is through prices, and is considered part of the normal functioning of the market. Alternatively, these effects are sometimes called "pecuniary externalities", with externalities as defined above called "technological externalities." This article considers only the latter.

Externalities are important in economics because they may lead to inefficiency (see Pareto efficiency). Because the producers of externalities do not have an incentive to take into account the effect of their actions on others, the outcome will be inefficient. There will be too much activity that causes negative externalities such as pollution, and not enough activity that creates positive externalities, relative to an optimal outcome. As noted, external costs also can imply political conflicts, rancorous lawsuits, and the like.

Many of the most important externalities in the economy are concerned with pollution and the environment. See the article on environmental economics for more discussion of externalities and how they may be addressed in the context of environmental issues.

Table of contents

1 Externalities in Supply and Demand

1.1 Negative Externalities
1.2 Beneficial Externalities

2 Externalities and the Coase theorem
3 See also

Externalities in Supply and Demand

Externalities can be illustrated on a standard supply and demand diagram if the externality can be monetized (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 (in competitive markets, the marginal private cost) and the other curve is the true cost that society as a whole pays for production and consumption of increased production the good (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

The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market -- before pollution-control laws were imposed and enforced (e.g., under laissez faire). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of the smoking stacks and water pollution. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.

If the consumers only take into account their own private cost, they will end up at price P_p and quantity Q_p, instead of the more efficient price P_s and quantity Q_s. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased only 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 less than the societal cost, so society as a whole would be better off if the goods between Q_p and Q_s had not been produced. The problem is that people are buying and consuming too much steel.

This discussion implies that pollution is more than merely an ethical problem; it is more than just "greedy" (profit-maximizing) firms. The problem is one of the disjuncture between marginal and social costs that is not solved by the free market. There is a problem of societal communication and coordination to balance benefits and costs. This discussion also implies that pollution is not something solved by competitive markets. In fact, a monopoly might be able to use some of its excess profits to be benevolent and internalize the externality (pay the cost of the pollution). More likely, a monopoly would artificially restrict the quantity supplied in order to maximize profits. This would actually benefit society in this situation because it would mean less pollution than in the competitive case. Perfectly competitive firms have no choice but to produce according to market incentives (private costs): if one decides to internalize external costs, it implies higher costs than those of competitors and likely exit from the market. So some collective solution is needed, e.g., some sort of government program to ban or discourage pollution.

Beneficial Externalities

The graph below shows the effects of a positive or beneficial externality. For example, the industry supplying influenza vaccinations is assumed to be selling in a competitive market. The marginal private benefit of buying bees is less than the marginal social or public benefit by the amount of the external benefit, i.e., the fact that if one person gets the vaccination, others are less likely to get the 'flu even if they themselves are not vaccinated. This marginal external benefit of getting a 'flu shot is represented by the vertical distance between the two demand curves. Assume that there are no external costs, so that social cost equals individual cost.

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, i.e., goods where it is difficult if not impossible to exclude people from benefits. 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.

Externalities and the Coase theorem

Ronald Coase argued that individuals could organise 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;
the number of people involved is small; and
bargaining costs are very small.

Only if all three of these apply will individual bargaining 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 its pollution, it is difficult if not impossible for any one person to negotiate to be compensated for this transgression. It may extremely expensive even for all individuals to negotiate with the steel firm, especially since some individuals may be tempted to be "free riders," benefiting from the negotiations without paying any costs. Thus, most economists see the need for government to be involved with big external costs, to regulate the firm while paying for the regulation 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. In many cases, it is simpler to involve the government.

This does not say that the Coase theorem is totally irrelevant. For example, if a logger is planning to clear-cut a forest in a way that has a negative impact on the nearby resort, it is quite possible that the resort-owner and the logger could 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. In terms of the examples that started this entry, telling someone that his or her perfume is offensive may easily lead to its being replaced, while praising the clothes of the fancy dresser may encourage the wearing of similar clothes in the future. Of course, none of these bargains may work out as well as desired.

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.