Externalities in Economics
By Steve Bain
The term 'externalities' in economics refers to factors that are influenced by the usual production and/or consumption of goods and services but that are not accounted for by either the buyer or seller. In this sense those factors are external to the trade that took place between buyer and seller.
The existence of externalities is one of the most important problems for a free market economy to overcome because, left to its own devices, a market that generates significant external costs or benefits will either over allocate or under allocate goods and services.
Note the important (and often overlooked) point that markets can generate externalities that are beneficial as well as harmful. A beneficial externality is referred to as a 'positive externality' whilst a harmful externality is called a 'negative externality'.
You should also note that I referred to 'significant' costs or benefits because almost all free market trades create an externality of one sort or another no matter how minor. The key point relates to whether or not the externality creates a big enough cost to society that some sort of government action is desirable in order to push for a more socially optimal quantity of output.
Inefficiencies caused by Externalities
Since externalities create oversupply or under-supply of a product, it follows that free-markets do lead to some inefficiency. This is not a rebuttal of free-market economics, because there is no cost-free perfect solution, all types of economic systems lead to suboptimal outcomes. It does, however, require that any objective assessment of an industry should attempt to account for the magnitude of inefficiencies caused by externalities, and establish whether any corrective action is justified.
In the vast majority of cases no corrective action is justified, because the inefficiencies are small and any corrective action would likely lead to unnecessary complications, excessive bureaucracy, and significant implementation costs.
Efficiency is optimized for an industry when its product creates an overall marginal social benefit that is equal to its marginal social cost. Private firms and consumers will only arrive at an outcome where marginal private benefit (more commonly known as marginal revenue) is equal to marginal private cost (usually referred to simply as marginal cost).
The difference between these outcomes is measured by the marginal external cost and marginal external benefit. For a clearer explanation of these concepts, illustrated with diagrams, have a look at these articles:
A Positive Externality & Negative Externality
The list of examples of positive and negative externalities is endless, but the two textbook examples that are most frequently given relate to vaccines in the case of a positive externality, and pollution as a negative externality.
In practice, it is negative externalities that dominate the literature in economics because it is these sorts of problems that present themselves more often, and that create more demands from the public to correct. For this reason, I'll put a little extra focus on negative externalities and the sorts of government policies that are available to address the costs to society that they create.
The example of vaccinations against a bacteria or virus is often given in the textbooks because of the external benefits that accrue to all people when some people get vaccinated. The benefit here occurs because someone who has had a vaccine not only protects him/herself from contracting a bug, but also anyone else that they might otherwise have passed the bug on to.
This is an important benefit to society, but an individual who gets a vaccine and a supplier who produces it tend only to take into account the individual costs and benefits. A free market economy would tend, therefore, to under-allocate vaccines if left to market forces alone.
Because of this problem, it is much more typical that the government will take action to increase the allocation of vaccines by paying for them out of general taxation. This makes them free at the point of use, and that encourages uptake of the vaccine.
In special circumstances, such as we have experienced in the wake of the Covid-19 global pandemic, a government may go to much more stringent means of encouraging uptake of a vaccine, but I won't be getting into that as it is politically heated and not relevant to the general point about the positive external benefits of vaccinations.
In keeping with my use of politically charged topics as examples of externalities in economics, pollutants are the obvious choice for our representative negative externality. We needn't get into the whole climate change debate here as it is not relevant to the general point. Instead let's consider the effects of a paint manufacturer that spills some chemical waste into a river.
If I choose to purchase some paint, I will not even be aware of the pollutants created in the production process, all I will consider is the asking price for the paint. The manufacturer on the other hand may be aware of the pollutants, but unaware of the damage being caused. In truth, even if the manufacturer is aware then production may continue regardless if the costs accrue to other people.
In this example, if the level of pollution is sufficient to kill the fish and other wildlife that depend on the river being clean, then the costs will be borne by fishermen and wildlife enthusiasts. Again we will have a strong case for government intervention in order to improve outcomes for society as a whole rather than just for the internal market participants (i.e. buyer and sellers).
There are several potential options for remedying this situation, and they range from total bans on production, to taxes on production, to tradable pollution permits. Below are a few examples of the sorts of controls on pollution that have been most popular with government legislators:
The most basic form of control, with regard to limiting pollution levels, is to place an emissions standard on firms that gives them a strict limit on the amount of pollutants that they are permitted to create. This may be set at a zero level if no pollution at all is deemed necessary.
Any emissions standard will likely be related to the amount of production that a firm undertakes, since larger firms will clearly need a larger permit than smaller firms. Any firm that goes over its permit level will be subject to prosecution and hefty financial (and possibly criminal) charges.
As with all forms of control, this requires that the authorities can accurately detect any infringement of the rules and punish it accordingly. This is not always easy to do, as was famously demonstrated by Volkswagen and the manipulation of the emissions testing of its cars to cheat the pollution regulations. Volkswagen's actions were eventually uncovered, and the ensuing punitive action was severe, but there may be many other 'cheats' across other industries that we simply don't know about.
An alternative to fixed limits on the amount of acceptable pollution is to simply levy a tax on a firm's pollution, i.e. to levy a 'Pigou tax'. The taxes that are raised can then be used as payment to compensate any third-party that suffers a cost from the pollution, or it can be used to pay for clean-up operations.
If the tax represents a significantly large cost of production then it will give a significant advantage to those firms that have more environmentally friendly production methods, and thereby create a strong incentive for an industry to replace dirty technologies with cleaner technologies.
Different countries have favored taxes over standards and vice-versa, and both have their pros and cons, but a better solution in many cases is offered by tradable pollution permits and it is unfortunate (if not surprising) that governments have failed to make more use of them - they remain an underutilized resource in the fight to correct externalities to this day.