eco

1. Externalities Definition
The origins of ‘externality’, comes from the Latin word ‘externus’ – meaning
‘outside’ or ‘outward’. Essentially, it translates to the state of being outside –
although its economics definition is more meaningful.
In economics, externalities are a cost or benefit that is imposed onto a third
party that is not incorporated into the final cost. For example, a factory that
pollutes the environment creates a cost to society, but those costs are not
priced into the final good it produces.
These can come in the form of ‘positive externalities’ that create a benefit to a
third party, or, ‘negative externalities’, that create a cost to a third party.
What’s more, these externalities occur both during production and/or
consumption.
Key Points
 An externality is a cost or benefit imposed onto a third party, which is
not factored into the final price.
 There are four main types of externalities – positive consumption
externalities, positive production externalities, negative consumption
externalities, or negative production externalities.
 Externalities create a social cost where goods are undersupplied or
create damage to the environment.
Production externalities occur when a manufacturer releases pollution into the
atmosphere during its production process. There are also consumption
externalities that occur during the consumption of a good. For example,
smokers release toxic fumes into the atmosphere that can be detrimental to
the health of those who inhale the fumes – thereby creating a negative
externality through pollution.
Positive Production Externalities
Positive production externalities occur when a third party benefits from the
production of another. The issue arises when the third party cannot be
charged for receiving such benefits. For example, a bakery may send the
smell of fresh bread through the mall. Yet all those who benefit are not
charged, and the baker has no way of charging them either.

2. . Local Construction
The construction of new local businesses and other amenities may increase
the value of local properties – thereby creating a positive benefit to local
residents. They also create jobs that provide income to residents, which can
then further stimulate economic activity in the locality. In turn, local residents
benefit even if they do not use such a business.
2. New Technology / Process
The advancement of technology has inevitably’ created private benefits. Many
firms benefit from productivity gains, which has created positive spillover
effects.
For example, if business A is spending $10 million less on producing jumpers,
it means those resources can be spent elsewhere. Rather than $10 million
being spent on producing the same number of jumpers, it can be spent on
producing a new style of pants or more staff. Those new pants may become
incredibly popular, but wouldn’t be achieved without the initial productivity
gains from technology.
3. Training
A business may train its employees with a specific skill, with the business and
employee both sharing the benefits and productivity gains. However, when the
employee leaves, the new employer will benefit from the original training and
skills acquired.
Examples include training such as First Aid, or Mental Health training,
whereby third parties can save lives or help individuals outside of the
company. Therefore training can also benefit parties from outside of the firm
as well.
4. Pharmaceuticals
Innovation in the pharmaceutical market is a debated and highly charged
topic. For instance, it charges high prices due to research and development
costs and risk factors. However, it can provide positive external benefits. If a
new drug saves a life, it produces a private benefit to the company as well as
the saved individual. At the same time, other parties also benefit. For
example, family and friends no longer have to fear losing a close friend or
loved one, and the grief it would bring.

3. Positive Consumption Externalities
Positive consumption externalities occur when a third party benefits from
somebody else’s consumption. Let us take some examples:
. Advertising
When McDonalds, Walmart, or some other big firm advertises, it solves
a market failure. For example, it allows services such as Twitter, free-to-air
television, and YouTube, remain free. So when you’re watching a YouTube
video; you are benefiting from advertisers paying YouTube. Whilst adverts can
be annoying, they allow us to view and use such services for free.
2. Education
The procurement of any form of education has the potential to benefit a third
party. For example, learning how to read and write at school benefits society
as a whole because we communicate more effectively. Without an education,
we would not be able to read now, nor would we be able to communicate
effectively. For every article or post you read, you are the third party that
benefits from that individual’s education.
3. Insurance
Having insurance can create a positive externality. For example, when a third
party has their vehicle totaled by a reckless driver, it can create a nightmare
situation. There may be $30,000 worth of damages and without the culprit
having insurance, they may have to shoulder the cost themselves.
The reckless driver may not have the money to pay for the damages so the
third-party has a cost imposed upon them. However, insurance resolves this
issue. Should a third party be injured or their car damaged, they can make a
claim.
4. Local Investment
Neighbours may invest in their property – developing a new drive or making
their house more pleasantly attractive. In turn, this can result in increased
market values to third parties in the local area if it makes the area seem more
desirable and picturesque.
5. Vaccinations / Personal Hygiene
When we receive vaccinations or take steps to prevent ourselves from
contracting a contagious disease, we pass on a benefit to a third party. As a
result, we decrease the likelihood of disease from spreading.

4. Negative Externalities
Negative externalities impose a cost onto a third party without prior knowledge
or consent. These externalities occur during an economic transaction between
two parties. There are then negative consequences that result, which the third
party is not compensated for.
It is said that these negative externalities cause social costs. For example,
CO2 contributes to global warming, damage to the environment, and the
ozone layer. This is a social cost that is burdened upon all of society.
Therefore, the use of CO2 emitting goods creates a negative externality that
brings a cost to society. One solution that is frequently cited, is to enforce
payment on such individuals or organizations and then redistribute this to the
affected parties.
Examples of Negative Externalities
A negative externality is where a cost is imposed onto a third party
involuntarily. In turn, governments generally look to step in to resolve such
issues. After all, it is hardly fair to have to pay for something that is somebody
else’s fault.
These externalities can be split down into production and consumption:
Examples of Negative Production Externalities
 Air pollution
 Noise pollution
 Construction New Houses
Examples of Negative Consumption Externalities
 Smoking and Air Pollution
 Rising Obesity
 Litter
 Traffic
Negative Production Externalities
1. Air pollution
As manufacturers produce cars, televisions, and other goods – they leave
Carbon emissions. An example of this was visible in 1952 during ‘The Great
Smog of London’. Over the course of 5 days, it is estimated that 6,000 died

5. from air pollution. Obviously this is a very extreme case but is an example of
how there can be serious external effects from air pollution.
2. Noise pollution
You may live on a main road, or have noisy neighbours. Either way, a third
party cost is imposed upon you through noise pollution. In some studies, this
can be associated with increased blood pressure and heart conditions.
Obviously a very serious externality.
3. Construction of New Houses
If more houses / apartments are being built in the local area; the value of the
surrounding houses will likely take a hit. As there is more supply in the area,
existing home-owners may find it less profitable to sell.
Negative Consumption Externalities
1. Smoking and Air Pollution
Slightly different from industrial pollution; smoking is a form of consumption
that impacts on a third party. The effects are widely known and can be
associated with a higher risk of cancer.
2. Rising Obesity
Higher obesity levels are associated with health conditions such as heart
disease. This is a private cost but can impose an additional cost on third

6. parties. As a result, the treatment required has to be paid for, which can come
in the form of higher insurance costs; impacting other customers. Or, in
government-run systems, it will be paid for by the taxpayer.
3. Litter
After consuming a beverage or food item, the leftover packaging may be
thrown on the floor. This creates a cost to the average passer-by in the form
an unpleasant sight, as well as the impact on the natural environment.
4. Traffic
In big cities, traffic is a nightmare. People will spend hours of their lives stuck
in it. Yet the third-party that pays the cost is other users.
Private vs Social Costs
To understand externalities, it is important to understand the imposed costs.
These come in the form of private, social, and external costs.
 A Private Cost is essentially the price paid by a person or firm for a
product/service.
 A Social Cost is the sum of the Private Cost in addition to any external
costs.
 An External Cost refers to the externalities discussed above. So for
example, the cost of air pollution may come to $50, so would be
included as an ‘external cost’.
Social Cost = Private Cost + External Cost
Example of Social Cost
A social cost is the sum of a private cost in addition to an external cost
(negative externality). The cost to use your car in the morning may by $5. That
is the private cost.
There are external costs that include: air pollution, noise pollution, and traffic.
Obviously, it is extremely difficult to value such externalities, which makes
calculating the total social cost very complex and open to interpretation.
Nevertheless, for this example, let us assume these costs amount to $2.50 –
that is the external cost. So the overall social cost would be $5 in private costs
plus $2.50 in external costs, leading to a total of $7.50.

7. Social Cost $5 in Petrol + $2.50 in cost of air and noise pollution
Importance of Social Cost
When the social cost exceeds private cost, we have what is commonly known
as market failure. This is because all of the total cost is not paid by the
customer. So for example, when a plane flies, it causes noise and air
pollution. The customer pays for their flight, but there is an external cost
imposed on a third party that is not paid for by the customer. This is
essentially what carbon emission taxes seek to address.
Remedies to Externalities
1. Refined Property Rights
When there are refined property rights, all parties are able to negotiate the
cost of the externality. For example, an owner of a fishery may be affected by
downstream pollution from an industrial firm. The owner of the fishery is able
to sue the industrial firm in order to be compensated for the effect it has had
on them. In turn, a settlement can be reached to be reimbursed for that
negative externality.
2. Taxes
When there are externalities such as pollution, one remedy is to tax them
based on units of consumption. For example, a firm that produces 10
thousand tonnes of C02 will be taxed at a rate of $1,000 per tonne. These
taxes could then be used to pay for positive externalities such as education
and other public goods.
3. Subsidies
Positive externalities are underproduced when the whole social benefit is
greater than the private benefit. In such situations, the good is underproduced
because private individuals value the good at a lower rate than the overall
value it provides to society. One way to resolve this is by offering subsidies

8. and other financial incentives. For instance, many governments offer a ‘green
scheme’ to make it more affordable to purchase electric cars.
4. Regulation
Another remedy to address externalities is regulation. By making negative
externalities illegal, they may address some of the side effects that occur and
reduce its consumption and production. For instance, many countries have
now made it illegal to smoke in a public place, which has helped reduce the
effects of second-hand smoke.
Negative externalities impose a cost onto a third party without prior knowledge
or consent. These externalities occur during an economic transaction between
two parties. There are then negative consequences that result, which the third
party is not compensated for.
It is said that these negative externalities cause social costs. For example,
CO2 contributes to global warming, damage to the environment, and the
ozone layer. This is a social cost that is burdened upon all of society.
Therefore, the use of CO2 emitting goods creates a negative externality that
brings a cost to society. One solution that is frequently cited, is to enforce
payment on such individuals or organizations and then redistribute this to the
affected parties.
Examples of Negative Externalities
A negative externality is where a cost is imposed onto a third party
involuntarily. In turn, governments generally look to step in to resolve such
issues. After all, it is hardly fair to have to pay for something that is somebody
else’s fault.
These externalities can be split down into production and consumption:
hese externalities can be split down into production and consumption:
Examples of Negative Production Externalities
 Air pollution
 Noise pollution
 Construction New Houses
Examples of Negative Consumption Externalities
 Smoking and Air Pollution
 Rising Obesity
 Litter
 Traffic

9. Negative Production Externalities
Remedies to Externalities
1. Refined Property Rights
When there are refined property rights, all parties are able to negotiate the
cost of the externality. For example, an owner of a fishery may be affected by
downstream pollution from an industrial firm. The owner of the fishery is able
to sue the industrial firm in order to be compensated for the effect it has had
on them. In turn, a settlement can be reached to be reimbursed for that
negative externality.
2. Taxes
When there are externalities such as pollution, one remedy is to tax them
based on units of consumption. For example, a firm that produces 10
thousand tonnes of C02 will be taxed at a rate of $1,000 per tonne. These
taxes could then be used to pay for positive externalities such as education
and other public goods.
3. Subsidies
Positive externalities are underproduced when the whole social benefit is
greater than the private benefit. In such situations, the good is underproduced
because private individuals value the good at a lower rate than the overall
value it provides to society. One way to resolve this is by offering subsidies
and other financial incentives. For instance, many governments offer a ‘green
scheme’ to make it more affordable to purchase electric cars.
4. Regulation
Another remedy to address externalities is regulation. By making negative
externalities illegal, they may address some of the side effects that occur and
reduce its consumption and production. For instance, many countries have
now made it illegal to smoke in a public place, which has helped reduce the
effects of second-hand smoke.