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.
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:
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.
An emissions tax is generally preferable to an emission standard in cases where the firms in an industry either have different costs of abatement (i.e. different levels of expense necessary to reduce pollutants by a given amount) or unknown abatement costs. The reason for this is because it will incur higher costs to the industry as a whole if some firms have to pay more than others.
Economic efficiency requires that the maximum amount of pollution reduction be achieved with the minimum cost overall, and if some firms can reduce an extra unit of pollution more cheaply than another firm can reduce a unit of production, then there are inefficiencies inherent in the industry. Of course, it may be that over time the industry will evolve into one where pollution abatement costs are more or less equalized, but by that time some firms may have been forced into bankruptcy.
The problem with an emissions tax is that it does not directly fix the overall level of pollution to an allowable amount, and so long as firms pay the taxes then the level may continue at an unacceptably high level. In that case an emissions standard may be preferable, but again, tradable pollution permits would likely be an even better option.
The most efficient way of reducing emissions depends heavily on how costly it is for individual private firms, and an industry as a whole, to 'abate' those emissions. This is explained in more detail in my article about the:
A tariff always refers to taxes on imported goods, and a carbon tariff refers to a tax on imported goods that create negative externalities. This brings the international context into focus when considering policies aimed at tackling global warming.
This is necessary since it would make little sense to tax/restrict a domestic industry into bankruptcy if it simply leads to foreign firms increasing their production levels - this would be particularly counter-productive if those foreign producers were using less clean production techniques since overall global pollution levels would increase rather than decrease (to say nothing of the costs of domestic bankruptcies and increased unemployment levels).
Carbon tariffs can be used as a way to encourage foreign firms to adapt their production techniques to more environmentally friendly techniques even if foreign governments are reluctant to enforce any agreed global accords on emission levels.
An important distinction to be aware of with externalities in economics relates to the nature of how third party costs and benefits arise. In most cases you will find that the relevant issue relates to a flow concept. By this I mean that the externality occurs immediately and constantly over time e.g. if a nightclub/discotheque opens near a residential area, it will probably create significant noise pollution for local residents, that noise flows immediately and constantly whenever the club is open, and it stops when the club closes.
In contrast, some of the biggest issues in economics relate to stock externalities. In this case there will be a flow of externalities that build up into a significant problem over time. For example, if concerns over climate change are correct and excessive carbon emissions are indeed responsible for catastrophic global warming, then it is the build up of emissions in the atmosphere that would cause this problem, rather than the flow.
It is the 'stock' of total emissions in the atmosphere that creates the 'greenhouse effect', and if the flow of pollutants is greater than the natural dissipation then there will be a continual build up. Eventually, so the theory goes, a critical mass will be reached at which point the level of emissions will be so high that it becomes too late to prevent the global warming consequences at some point in future.
In some cases there is both a stock and a flow impact. The vaccine example demonstrates this quite well, because every person that gets an effective vaccine will pass on some protection against contracting the virus to people who are not vaccinated - indicating the benefits of a positive flow of externalities.
Additionally, once a population reaches a critical mass of vaccinations, the threat posed by that virus is much reduced because it cannot spread i.e. its 'R number' will fall below one and it will start to decline. That critical mass of vaccinations represents a positive stock externality.