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Externalities, Economic Lowdown Podcasts
Externalities occur when some of the costs or benefits of a transaction fall on someone other than the producer or the consumer. Learn more about externalities in this podcast.
Externalities - The Economic Lowdown Podcast Series
Ever feel as if you are paying the price for someone else’s “deal”? Perhaps you are choking on the pollution from a foundry where cheap widgets are made. That spillover effect is called an externality. There are positive ones, too. Learn more about externalities in this episode of the Economic Lowdown Podcast Series.
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What do pollution, education, and your neighbor's dog have in common?
No, that's not a trick question. All three are actually examples of economic transactions that include externalities.
When markets are functioning well, all the costs and benefits of a transaction for a good or service are absorbed by the buyer and seller. For example, when you buy a doughnut at the store, it's reasonable to assume all the costs and benefits of the transaction are contained between the seller and you, the buyer. However, sometimes, costs or benefits may spill over to a third party not directly involved in the transaction. These spillover costs and benefits are called externalities. A negative externality occurs when a cost spills over. A positive externality occurs when a benefit spills over. So, externalities occur when some of the costs or benefits of a transaction fall on someone other than the producer or the consumer.Negative Externalities
Imagine there's a factory in your town that produces widgets, a good that benefits consumers all over the world. The smokestacks at the factory, however, belch out pollution 24/7. From an economic perspective, the firm is shifting some of its cost of production to society. How? Well, in its production process the firm uses clean air-a resource it does not pay for-and returns polluted air to the atmosphere, which creates a potential health risk to anyone who breathes it. If the firm were paying the full cost of production, it would return clean air to the atmosphere. Instead, if society wants clean air, society must pay to clean it. So, in this case, pollution represents the shifting of some of the cost of production to society, a negative externality. And, because the firm isn't paying the full cost of producing widgets, the price charged for widgets is artificially low. Consumers will buy more widgets at the artificially low price than at a price that reflects their full production cost. So, ultimately, more widgets are produced than would be the case if all costs were included. And since more widgets are being produced, more air is being polluted.Correcting Negative Externalities
Government can play a role in reducing negative externalities by taxing goods when their production generates spillover costs. This taxation effectively increases the cost of producing such goods. The higher cost, then, better reflects the true cost of production because it includes the spillover costs of, say, pollution. So, such taxation attempts to make the producer pay for the full cost of production. The use of such a tax is called internalizing the externality. For example, let's assume the cost of producing the widgets noted earlier is two dollars per unit, but an additional 20 cents per unit had been shifted to society as a negative externality in the form of dirty air. The government could place a 20 cent tax on each widget produced to ensure that the firm pays the actual cost of production-which is now two dollars and twenty cents, including the cost of the negative externality. As a result of the higher cost of production, the firm will reduce its production of widgets thus reducing the level of pollution.Positive Externalities
When you complete high school, you'll reap the benefits of your education in the form of better job opportunities, higher productivity, and higher income. A technical degree or college education will further enhance those benefits. Although you might think you are the only one who benefits from your education, that isn't the case. The many benefits of your education spill over to society in general. In other words, you can generate positive externalities. For example, a well-educated society is more likely to make good decisions when electing leaders. Also, regions with a more-educated population tend to have lower crime rates. In addition, more education leads to higher worker productivity and higher living standards for society in general. Although education has many spillover benefits, providers of education do not receive all the revenue they would earn if the full benefits of the transaction were internalized. To state it differently, producers of education are not fully compensated for the benefits that spill over to society. As a result, producers of education will likely under produce education.
ECON 150: MicroeconomicsSection 01: Externalities
Adam Smith taught each individual, seeking only his own gain, "is led by an invisible hand to promote an end which was no part of his intention," that end being the public interest. However, there are times when the market outcome differs from the outcome that society considers optimal. This market failure may occur when there is an externality, an external benefit or cost that is enjoyed or imposed on a third party other than the buyer or seller of the good. For example, consider your answer to the following question:
What is the optimal level of pollution?
Most people would automatically give the answer that zero pollution would be optimal. However, the optimal level of pollution is not zero; instead, the optimal level is obtained by following our economic decision rule of equating the marginal benefit to the marginal cost.
When a negative externality is present, there is a cost imposed on a third party not involved in the production or consumption of the good. Examples of negative externalities include various forms of pollution, such as air pollution from factories or power plants, water pollution; noise pollution such as airports or even roommates; and drivers who are impeded by drugs, alcohol, or texting. Use the link below to view an ABC News 20/20 video clip on noise pollution.
Click here to watch the ABC News 20/20 video clip on "Too Much Noise."
If a factory is able to pollute without paying for the damages caused by the pollution, it will produce more than the socially optimal level of output. Since the firm only pays for the marginal private cost of producing the good or service, it will produce where the marginal private cost is equal to the marginal private benefit. But when there are externalities, the marginal private cost is not the same as the marginal social cost. The marginal social cost adds to the marginal private cost the cost of the externality, which graphically is the vertical distance between the marginal private cost and marginal social cost. If we were to account for the negative externality, the optimal level of production would be lower than the market quantity. As is, the excessive quantity of output creates a deadweight loss to society since the marginal social cost exceeds the marginal social benefit.
Externalities may exist in either the production or consumption of the good or service. Negative production externalities are generated when the good or service is produced such as factories polluting the air, water or land as they produce the good or service. Negative consumption externalities occur when the consumption of the good or service creates the externality, for example an individual that consumes alcohol at the bar then, when driving home, kills pedestrians due to his impairment.
Property that is held in common, such as air, water, and public lands, belongs to everyone as a whole. Consequently no one individual has an incentive to care for it, since it doesn’t belong to just her. In some college apartments, dishes pile up in the sink or the garbage doesn’t get taken out, because it belongs to everyone collectively and no one individually. When a resource belongs to everyone, individuals account only for the private marginal benefits and costs and fail to account for the impact of their actions on others, hence the tragedy of the commons.
For example, if the ocean is common property there is a tendency to overfish because fishermen only consider their private costs and do not account for how their larger catch makes it more costly for other fisherman to catch the fewer remaining fish. Similarly during the 19th century, American bison that once roamed much of North American were killed by the millions since they were a common resource. Because individuals actions fail to account for the impact on others, a negative externality exists.
When a positive externality is present, the market produces less than the socially optimal quantity of the good or service, since there is a benefit to society that is not captured by the individual. Education, for example, not only benefits the individual but also society as a whole since individuals often are creating new products and services and are less likely to be involved in violent crimes or on the welfare rolls of society. However, a student will only consider the marginal private benefit and the marginal private cost when determining the quantity of education that he or she should obtain.
Other examples of positive externalities include immunizations or a neighbor who fixes up his house which in turn increases the property value of other homes on the street. A deadweight loss also exists when there is a positive externality because at the market quantity, the marginal social benefit is greater than the marginal social cost.
When an externality exists, the socially optimal output is not achieved. A variety of different policies exist to correct these ranging from “command-and-control” to market-based policies.
Externalities: Prices Do Not Capture All Costs
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Externalities: Prices Do Not Capture All Costs
FINANCE & DEVELOPMENT
There are differences between private returns or costs and the costs or returns to society as a whole
Smoking is bad for you (photo: Radius Images/Corbis)
Consumption, production, and investment decisions of individuals, households, and firms often affect people not directly involved in the transactions. Sometimes these indirect effects are tiny. But when they are large they can become problematic—what economists call . Externalities are among the main reasons governments intervene in the economic sphere.
Most externalities fall into the category of so-called that is, the indirect effects have an impact on the consumption and production opportunities of others, but the price of the product does not take those externalities into account. As a result, there are differences between private returns or costs and the returns or costs to society as a whole.
Negative and positive externalities
In the case of pollution—the traditional example of a —a polluter makes decisions based only on the direct cost of and profit opportunity from production and does not consider the indirect costs to those harmed by the pollution. The indirect costs include decreased quality of life, say in the case of a home owner near a smokestack; higher health care costs; and forgone production opportunities, for example, when pollution harms activities such as tourism. Since the indirect costs are not borne by the producer, and therefore not passed on to the end user of the goods produced by the polluter, the social or total costs of production are larger than the private costs.
There are also and here the issue is the difference between private and social gains. For example, research and development (R&D) activities are widely considered to have positive effects beyond those enjoyed by the producer that funded the R&D—normally, the company that pays for the research. This is because R&D adds to the general body of knowledge, which contributes to other discoveries and developments. However, the private returns of a firm selling products based on its own R&D typically do not include the returns of others who benefited indirectly. With positive externalities, private returns are smaller than social returns.
When there are differences between private and social costs or private and social returns, the main problem is that market outcomes may not be efficient. To promote the well-being of all members of society, social returns should be maximized and social costs minimized. This implies that all costs and benefits need to be internalized by households and firms making buying and production decisions. Otherwise, market outcomes involve underproduction of goods or services that entail positive externalities or overproduction in the case of negative externalities. Overproduction or underproduction reflects less-than-optimal market outcomes in terms of a society’s overall condition (what economists call the “welfare perspective”).
Consider again the example of pollution. Social costs grow with the level of pollution, which increases in tandem with production levels, so goods with negative externalities are overproduced when only private costs are considered in decisions and not costs incurred by others. To minimize social costs would lead to lower production levels. Similarly, from a societal perspective, maximization of private instead of social returns leads to underproduction of the good or service with positive externalities.
Taxation and externalities
Neoclassical economists long ago recognized that the inefficiencies associated with technical externalities constitute a form of “market failure.” Private market–based decision making fails to yield efficient outcomes from a general welfare perspective. These economists recommended government intervention to correct for the effects of externalities. In , British economist Arthur Pigou suggested that governments tax polluters an amount equivalent to the cost of the harm to others. Such a tax would yield the market outcome that would have prevailed with adequate internalization of all costs by polluters. By the same logic, governments should subsidize those who generate positive externalities, in the amount that others benefit.
The proposition that technical externalities require government regulation and taxation to prevent less-than-optimal market outcomes was intensely debated after Pigou’s seminal work. Some economists argued that market mechanisms can correct for the externalities and provide for efficient outcomes. People can resolve the problems through mutually beneficial transactions. For example, a landlord and a polluter could enter into a contract in which the landlord agrees to pay the polluter a certain amount of money in exchange for a specific reduction in the amount of pollution. Such contractual bargaining can be mutually beneficial. Once the building is less exposed to pollution, the landlord can raise rents. As long as the increase in rents is greater than the payment to the polluter, the outcome is beneficial for the landlord. Similarly, as long as the payment exceeds the loss in profit from lower pollution (lower production), the polluter is better off as well.