Question

What is an externality? Give an example of a positive externality, and give an example of a negative externality.

Short answer

An externality is a consequence of an economic activity experienced by unrelated third parties. It can be either positive or negative. A positive externality example is the effect of a well-educated labor force on the productivity level of a company. A negative externality example is pollution from a factory affecting the surrounding environment and health of nearby residents.

Step-by-step solution

Defining Externality

Externality in economics refers to a consequence of an industrial or commercial activity which affects other parties without this being reflected in market prices. It's the impact of one person’s actions on the well-being of a bystander. Externalities can either be positive or negative.

Example of Positive Externality

A positive externality is a benefit that is enjoyed by a third-party as a result of an economic transaction. An example could be the effect of a well-educated labor force on the productivity level of a company. That company might not have contributed to the education of its employees but enjoys the benefits nonetheless.

Example of Negative Externality

A negative externality is a cost that is suffered by a third party as a consequence of an economic transaction. An example could be the pollution emitted by a factory that spoils the surrounding environment and can affects the health of nearby residents. The costs of the factory's pollution are not paid by the factory but are borne by its neighbors or society as a whole.

Key concepts

Positive Externality

A positive externality occurs when an economic transaction results in benefits to a third party that is not directly involved in the transaction itself. This is often seen as a byproduct of actions or decisions made by firms or individuals that create an advantageous situation for others.
For example, when someone plants a garden, the community might enjoy the aesthetic beauty, or bees might benefit from the added flora, promoting their survival and pollination activities. Another common example of positive externalities is education. When individuals receive education, they tend to become more productive workers and better citizens. The benefits of their education extend beyond themselves, improving economic growth and fostering community well-being.
Positive externalities often lead to under-provision of the related good or service since the full benefits are not captured by the individuals or firms responsible for them. Therefore, government policies, like subsidies, are sometimes necessary to encourage such activities by internalizing these external benefits.

Negative Externality

Negative externalities occur when a transaction imposes costs on third parties who did not choose to incur those costs. They are the undesirable consequences of economic activities, often left unaddressed by the market because these costs are not reflected in prices.
Pollution is a classic example. When a factory releases emissions into the air, it imposes health and environmental costs on the local population and ecosystems. These costs are not paid by the factory, leading to overproduction of the goods causing pollution.
Addressing negative externalities is crucial for maintaining societal welfare. Governments often intervene with regulations, taxes, or pollution permits to ensure that the polluter bears some or all the costs of their actions. This not only helps mitigate harm but also encourages firms to adopt cleaner technologies.

Market Prices

Market prices are the reflection of the value of goods and services in an economy, determined by the forces of supply and demand. They serve as vital signals for allocating resources effectively, guiding consumers and producers in their economic decisions.
However, when externalities are present, market prices can mislead. Positive externalities can result in lower than optimal consumption or production since some benefits are not taken into account. Conversely, negative externalities can lead to excessive production or consumption as some costs are ignored.
The role of market prices becomes more complex when they do not incorporate external costs or benefits. This is why interventions are sometimes necessary to adjust market outcomes to better align with societal welfare, ensuring that prices more accurately reflect true social costs and benefits.

Third-Party Effect

The term third-party effect describes how actions between two parties in an economic transaction affect a third party not involved in the transaction. This effect is central to the concept of externalities—both positive and negative—because these externalities are impacts felt beyond the originating parties.
For instance, if a company decides to build a factory, the transaction involves construction companies, the factory owner, and perhaps the local government. However, nearby residents might experience increased traffic, noise, or pollution due to the factory. These impacts are the third-party effects not accounted for in the original decision-making process.
Understanding third-party effects is essential for establishing policies that mitigate negative externalities and enhance positive externalities. By taking into account how actions indirectly affect others, economists and policymakers can devise strategies that promote overall societal well-being, sometimes involving creating incentives or regulations to address these indirect consequences.