Externalities
Introduction
An externality is a consequence of an economic activity that is experienced by unrelated third parties. It can be either positive (beneficial) or negative (detrimental). Externalities are a form of market failure, where the market does not allocate resources efficiently. Market failures are often used as a justification for government intervention in the economy.
Types of Externalities
Externalities can be categorized into four main types: Positive and Negative, and Direct and Indirect.
Positive Externalities
Positive externalities occur when the actions of a person or firm have a positive effect on others. For example, the beekeeper who keeps the bees for their honey also provides a benefit to the farmer next door, as the bees will naturally pollinate the crops. The benefit to the farmer is not considered by the beekeeper, hence it is an externality.
Negative Externalities
Negative externalities occur when the actions of a person or firm have a negative effect on others. For example, a factory that pollutes the air or water creates a negative externality that can affect the health and property values of people in the surrounding area.
Direct Externalities
Direct externalities occur when the actions of a person or firm directly affect others. For example, if a person smokes in a public place, the smoke is a direct externality that can affect the health of others in the vicinity.
Indirect Externalities
Indirect externalities occur when the actions of a person or firm indirectly affect others. For example, if a person buys a car and contributes to traffic congestion, this is an indirect externality.
Externalities and Market Failure
Externalities are a type of market failure, where the market does not allocate resources efficiently. This is because the social cost or benefit of the activity is not reflected in the market price. As a result, goods or services may be overproduced or underproduced, leading to a loss of economic efficiency.
Negative Externalities and Market Failure
In the case of negative externalities, the social cost of the activity is greater than the private cost. This means that the market price does not reflect the true cost of the activity, leading to overproduction. For example, a factory that pollutes the air does not bear the full cost of the pollution, which is borne by society. As a result, the factory produces more than the socially optimal amount.
Positive Externalities and Market Failure
In the case of positive externalities, the social benefit of the activity is greater than the private benefit. This means that the market price does not reflect the true benefit of the activity, leading to underproduction. For example, a person who gets vaccinated against a disease not only benefits themselves, but also others by reducing the spread of the disease. However, the market price of the vaccine does not reflect this social benefit, leading to under-vaccination.
Externalities and Public Policy
Governments often intervene in the economy to correct market failures caused by externalities. This can be done through various policy measures, such as taxes, subsidies, regulations, and property rights.
Taxes and Subsidies
Governments can use taxes and subsidies to correct market failures caused by externalities. For example, a tax can be imposed on a factory that pollutes the air to make it bear the full cost of the pollution. This would reduce the factory's production to the socially optimal level. On the other hand, a subsidy can be given to a person who gets vaccinated to reflect the social benefit of vaccination. This would increase the vaccination rate to the socially optimal level.
Regulations
Governments can also use regulations to correct market failures caused by externalities. For example, a government can impose emission standards on factories to limit air pollution. Or it can mandate vaccination for certain diseases to increase the vaccination rate.
Property Rights
Another way to correct market failures caused by externalities is through the establishment of property rights. For example, if property rights to clean air are clearly defined and enforced, people can sue a factory that pollutes the air for violating their property rights. This would force the factory to bear the full cost of the pollution, reducing its production to the socially optimal level.
Conclusion
Externalities are a key concept in economics and public policy. They represent a form of market failure where the market does not allocate resources efficiently. Governments often intervene in the economy to correct market failures caused by externalities, using policy measures such as taxes, subsidies, regulations, and property rights.