A broad term in economic theory which denotes any good or service whose allocation is not or cannot be controlled effectively by price systems. Externalities are measured as a balance between the cost to the individual producer or consumer of the good or service and the cost to society as a whole.

A negative externality is one where the costs to society is higher than the cost to the producer. A textbook example of this is clean air. Air is free; there is no effective way to charge for (clean) air, so factories and automobile drivers do not hesitate to pollute it in the absence of emissions controls and guidelines.

A positive externality, conversely, is one where the benefits to society are higher than the benefits to the producer, i.e.: the producer does not reap the full economic benefit of producing the good. Examples include: research, education, public gardens. A positive externality is sometimes called a public good.

Externalities are the basis of the theoretical justification for much government legislation. Negative externalities are addressed with fines, taxes and permits, and sometimes by creating credits for the externality that can be traded in a market. Positive externalities are addressed with grants and subsidies.

Some stuff on negative externalities: how to get rid of them

A quick economic lesson - some of the stuff below is culled from one of my old essays, so there might be one or two obscure references. Oh, and some of the pipelinks are thoroughly random.

A negative externality is a situation where the the social costs (the marginal social cost - the MSC) is higher than the private cost (the marginal private cost - the MPC) - that is, a scenario where individual consumption or production of a good adversely effects society more than the individual. Goods that cause negative externalities are called demerit goods.

We normally get negative externalities when property rights are ill-defined - nobody owns the atmosphere so we feel free to mess it up. People dump trash in rivers because there's no one to sue them, as no-one actually owns the water.

Below are the primary methods of resolving negative externalities, and some examples.

1. Taxes

Mark Twain

Consider a good that exhibits a negative externality: cigarettes. As cigarettes are valued more by the individual than society, they can be considered to be demerit goods, and as a result the marginal social cost to society is greater than the marginal private cost, and this leas to overprovision of cigarettes in the free market.

Of the price of a cigarette in the UK, more than 75% is tax, and the reason taxes are used to resolve the externality is because they internalise the cost.

Say the gap between the marginal social cost and the marginal private cost was X, then by levying a tax of X on the cigarette producing company the firm will operate where marginal social benefit is equal to marginal social cost.

Taxes effectively push the marginal private cost to the left, creating an incentive for the company to reduce production.

Note: this really needs a graph, so go here: http://www.bized.ac.uk/virtual/vla/theories/negative_externalities.htm for some good ones.

The main disadvantage of using tax is that in order to make the marginal private cost equal to the marginal social cost, one must know the difference between the two in numerical terms, and this is often extremely difficult to do. The marginal social cost of cigarettes may be, among other things, cancer. The government setting a tax must calculate the cost in monetary terms, and this is nearly impossible to quantify.

If the government places too high a tax, it would be inefficient because it would lead to an under provision of cigarettes. If the tax is not large enough to shift the marginal private cost sufficiently to the left, then there will still be too many cigarettes because the cost will not be fully internalised.

In addition, most taxes are not continuous and are not linked to the amount of cigarettes produced or the amount of pollution released. This means that a one-off tax may have little long-term effect.

The advantages of tax are clear: if the amount of tax levied is correct, then they are an easy and simple way to internalise the costs.

However, the effectiveness of any tax also depends upon the price elasticity of the good in question: cigarettes, primarily because of influence of habit and also because of the lack of any close or viable substitutes, are relatively price inelastic. This means that if the government levied a tax on a tobacco company, the increase in costs could be passed on to the consumer in the form of higher prices.

The company would not lower production of cigarettes enough to cover the externality, and there would still be market failure. Higher taxes may then have an inflationary effect on the economy if producers do choose to pass on the costs.

Benjamin Franklin

2. Subsidies

Although not the best way to resolve negative externalities (as they are much better suited to internalising benefits when resolving positive externalities), subsidies can be used.

Taking the example of water pollution, say a firm is disposing of its waste in rivers. The private cost is low, but the social costs extremely high. In this case, marginal private cost is to the right of marginal social cost so the quantity produced is higher.The firm has effectively externalised its cost. By granting a subsidy to he firm, the government can make the company stop.


If the company were to start producing at the socially optimal level (MSB=MPC) then their costs would increase. So they don’t produce at that level.

But, if the government provides a subsidy equivalent or greater in value to the rise in costs, the company would have an incentive to start producing at the new level.

The disadvantages of subsidies, however, make them unlikely to be implemented: why would a government grant a subsidy when it has the power to levy a tax or create legislation that forces the company to stop polluting the water?

Subsidies are politically damaging because taxpayers have to ultimately bear the cost of the subsidy. Subsidies do not internalise the cost of pollution, and while they may be as effective as legislation or tax, they are not as acceptable to the public.

3. Legislation

Legislation is one of the most common ways of removing an externality. It simply forces a company to internalise the cost, and effectively sets the level at which a company may produce – the level at which production is set should be where MSB=MSC.

Consider the example of alcohol.

Alcohol is a demerit good, because it is valued more by the individual, and individual consumption has an adverse social effect. Companies can make alcohol, and collect revenue that is their private benefit. Yet in doing so they impose a cost on society. This means that the marginal private cost is low, but the marginal social cost is high.

These social costs could entail antisocial behaviour, crime and healthcare costs. Yet the people only care about the marginal private benefit and so alcohol will be overprovided, and a negative externality will have been created. Legislation, however, removes this.

The government can introduce laws that, for example, restrict the consumption of alcohol (for example, it can pass a law banning the consumption of alcohol in a public place) and this means that it has effectively set the quantity of alcohol produced – whatever the position of the MPC, the firm must (hopefully, if the legislation is set correctly) produce at that level where MSC=MSB.

The advantages of legislation are that no money has to be spent (unlike subsidies) and the externality is removed. However, the disadvantages are also high, because it is once again difficult to set the legislation so that the externality is precisely removed.

It is too easy for the legislation to be too harsh, and this would lead to too little alcohol being produced. In addition, legislation has to be enforced and if it isn’t it will become inefficient.

This is because say the government didn’t check whether or not companies actually followed the law: the firm would have no incentive to obey the legislation and would sell at whatever quantity they wanted to – this would mean the externality would not have been removed. Taxes don’t need constant enforcement, on the other hand.

Of course, another advantage of legislation is that it targets the problem effectively. If he marginal social cost consists mainly of teenagers drinking excessive amounts of alcohol then legislation can specifically target the problem, whereas taxes can be too broad and would indiscriminately limit production.

4. Permits

The reason we have a negative externality with pollution is that the air is a public good: since property rights for air are badly defined, people feel free to pollute the atmosphere. Consider the problem of firms creating air pollution through factories, for example. Pollution permits create a market for pollution, and they work like this:

The government can issue a fixed number of permits that allow a firm to release a certain amount of pollution. These permits can be traded.

If the government has calculated the socially optimum level of pollution where MSB=MSC, it will know the quantity of pollution that is optimal, and can release a corresponding amount of permits. Companies who are above their limit can purchase permits from other producers, and producers who are below their limit can sell their permits.

What this does is to (i) internalise the cost or (ii) if a company doesn’t want to internalise the cost it has to find a way of reducing the pollution, and so there is an incentive to develop greener and environmentally friendly equipment. Either way, the externality has been resolved.

The advantages of permits are that they are extremely cheap (unlike subsidies) and if the government reduces the number of permits as time goes on, there is a long-term incentive to reduce pollution levels, because it will save money. A one-off tax doesn’t create this long-term incentive. Permits also require little enforcement (unlike legislation).

Taxes also require knowledge of the cost of the externality, and this means that if pollution levels change and government targets change, taxes must also change.

A constantly fluctuating tax that tracks pollution levels may be effective, but it creates long-term uncertainty for companies because they can’t forecast profits. This uncertainty manifests itself as a fall in investment, which only has an adverse effect on the economy.

The introduction of permits means that firms would be free to choose whether to buy permits and pollute, or find environmentally better ways to produce. This means that there is more flexibility and companies can adapt at the rate they choose.

If, say, the externality becomes more harmful then the government can buy a certain quantity of permits reducing the supply and pushing the price up (other things being equal). This means although the externality has risen in value, the cost internalised is also higher.

It is clear, however, that the government needs to have some idea of the amount of pollution it wants – if it buys up too many permits, the price will rise too much and firms will be producing too little pollution: although that sounds beneficial, it is wholly unnecessary because a certain amount of pollution is acceptable. Why the hell do we need to curb the world opf every little piece of smoke? It would be economically inefficient.

Also take a look at these nodes, which are highly relevant:

Ex`ter*nal"i*ty (?), n.

State of being external; exteriority

; Metaph.

separation from the perceiving mind.

Pressure or resistance necessarily supposes externality in the thing which presses or resists. A. Smith.


© Webster 1913.
