Externalities | Definition and Examples

What are externalities?

Definition and explanation

Externalities are side effects of an action that don't affect the doer of that action, but instead affect bystanders. Positive externalities are good outcomes for others; negative externalities are bad outcomes.

Negative externalities

A negative externality is when you impose some cost on others through your actions, but you don’t incur any of the cost yourself. Think of a factory that produces cars and dumps its waste and emissions into the river - that polluted river harms the local community, but the factory doesn’t suffer for it. Economists call this a ‘negative externality’ because the action is causing a negative side-effect, and the side-effect falls on people other than you (external people).

Positive externalities

We can flip this around: a positive externality is when you provide some benefit to others through your actions, but you don’t reap all of that benefit for yourself. Think of the COVID-19 vaccines. A COVID vaccine benefits you if you get vaccinated, but it also creates an external benefit for others because if you are vaccinated then you are less likely to transmit the disease to others.

Here are some other examples of positive externalities:

Research & development - when someone invents a new idea they’re often not the only one to benefit economically from it.
Open-source software development. (Although this might not necessarily be due to purely altruistic motives - a tech company could be commoditizing their complement.)
Better education - a more educated population is also more productive, which makes everyone better off.

Examples of externalities in economics

Environmental externalities: Why we have too much pollution

Each time our polluting factory produces a car, it creates an external cost that is not paid for by the factory itself. Imagine that this factory can produce cars very cheaply because it dumps its waste in the river. If we only looked at the private costs of manufacturing the car (i.e. the costs of running the factory) we might conclude that society is getting a great deal with all these cheap cars.

But we’ve forgotten to add the social cost of all the pollution, which doesn’t show up on the factory’s balance sheet. So the true cost to society i.e the social cost (private cost + external cost) of these cheap cars is higher than we thought.

Economists care so much about positive and negative externalities because they have a large impact on what the optimal allocation of resources in society should be. When negative externalities from some activity are significant, then we tend to do too much of that activity.

Let’s take CO2 emissions as an example. CO2 emissions from airplanes create a negative externality, but that doesn’t stop everyone from flying off for their summer vacation - you still get your cheap vacation, and you don’t suffer from the incremental contribution to climate change that you’ve caused.

But if there was a government intervention that taxed CO2 emissions, this would make plane tickets more expensive (because it would include the cost of the carbon emissions). People would then probably fly less, as it got more expensive.

What we’ve done here is internalise the cost - we’ve transformed the external cost of CO2 emissions into a private cost that is paid for by the person doing the flying. Such a tax is called a Pigouvian tax - which is a tax on a good with external costs (for those who are technically minded, the Pigouvian tax brings up the price of the good to equal the marginal social cost).

Public health externalities: Why there isn’t enough vaccination

Let’s now think about vaccinations and positive externalities. Getting a vaccination is a bit annoying: you have to go to the pharmacy and no-one likes being poked by a needle. But a vaccine is also useful: so let’s say that you’re just about willing to pay $20 for a vaccination.

However, a vaccine not only protects you but produces a positive externality for others - you’re less likely to spread the disease to them. These spillover effects mean that vaccines are public goods, and therefore likely to be an example of underproduction in a free market equilibrium.

Let’s say that this external benefit is worth another $20 to the rest of society. So the total social benefit is $40 ($20 private benefit + $20 external benefit). The person who gets the vaccine shot bears all the costs of getting the vaccine, but doesn’t get all of the benefits - and so that means fewer people will get the vaccine shot that is economically efficient.

One solution to this is if the government paid out $20 subsidies (a Pigouvian subsidy) to people who got vaccinated, that would bring up the amount of people willing to get a vaccine to the economically efficient quantity. Notice how this works the same way but opposite in our carbon tax example: Subsidies are the opposite of taxes.

Solving the problem of externalities with markets

Insofar as an externality is a public good (averting a negative externality or providing a positive one), one approach is to use a non-profit entity like a government or non-profit to profit.

So far we’ve also discussed examples where Pigouvian taxes — named after the English economist Arthur Cecil Pigou — and subsidies can correct for externalities. But under the right conditions the market can create the optimal outcome, if there is systematic trading in the externalities.

Coase theorem

The Coase theorem (named after Nobel prize winning economist Ronald Coase) states that if it’s relatively easy to reach an agreement (low ‘transactions costs’) and it’s clearly defined who the third parties are that are getting affected by the externality (clear ‘property rights’), then private deals between parties will ensure that the outcome is the optimally efficient one.

The Coase theorem suggests a different approach to solving externalities - by creating new markets to trade in externalities. Indeed, some governments have helped create a market in the right to emit pollution such as the Clean Air Act in the USA.

Also check out:

Efficiency - Conceptually
Coase theorem - Marginal Revolution University
An introduction to externalities - Marginal Revolution University