What are externalities? Examples, sub-types, and impact

What are externalities?

In economics, the term ‘externality’ refers to the impact of an economic activity on an external or unrelated party. This impact can be either positive or negative. A defining characteristic of externalities is that the party bearing the consequences (either in the form of benefits, or increased costs), does not have any control over the factors that lead to the situation.

In this article, we will be sharing some examples of externalities that will help you understand the concept in a better way. We will also be discussing the different types of externalities and their effect on the market as a whole.

Types of externalities

There are four types of externalities, but they are classified under two heads: positive and negative.

Negative externalities

When an externality affects the third party in an unfavorable way, it is said to be negative. Unfortunately, most externalities today classify as negative.

Negative externalities can be further divided into:

  1. Negative consumption externalities
  2. Negative production externalities

If consumption of certain products, or use of certain services have negative effects on unrelated third party, the externalities would fall under the head of negative consumption.

 On the other hand, negative production externalities refer to the unfavorable effects that production of certain products have on a third party that is neither involved in the production, nor in the use of those products. Furthermore, the third party is not even compensated for their loss by the manufacturing firms.

The below-mentioned examples of externalities will help you understand these concepts in a better way.

Examples of negative consumption externalities

  • Smoking

Consuming cigarettes is not only harmful for the smoker’s own health but also affects those in the surroundings. They are forced to inhale the smoke, unintentionally and unwillingly. They are not involved in the manufacturing, sale, purchase or use of the product, however, they still have to bear the side effects of inhaling tobacco smoke while being totally unrelated to the entire process. The harmful consequences that non-smokers have to face due to the consumption of a product by someone else is a perfect example of negative consumption externality.

  • Alcohol consumption

Over-consumption of alcohol can make one behave abnormally. Since a drunk person usually loses control over his actions and thought process, he may indulge in activities that can irritate another person or destroy a pleasant experience for them – such as movie outing or a dinner date (which they have paid for). Since the individuals – disturbed by the drunk person – are not able to receive the expected value in return for the cost they incurred, this situation would classify as a negative consumption externality.

Examples of negative production externalities

  • Air pollution

When a product is manufactured, the toxic waste is released into the air, the quality of air deteriorates. Similarly, the burning of fossil fuels negatively affects the health of people living in surrounding areas. Since those people have nothing to do with the entire process, they are a third party in this scenario. Exposing them to health risks would be counted as a negative production externality.

  • Water pollution

Many manufacturing firms are socially irresponsible. Instead of treating their liquid waste, they drain it into the sea or other reservoirs of water. Since this liquid is contaminated with industrial waste and harmful chemicals, it affects marine life, and consequently that of individuals who unknowingly buy and consume this contaminated seafood. This is another example of negative production externality.

Positive externalities

Positive externalities refer to incidents where economic activities affect an external party in a favorable and beneficial manner.

Positive externalities can also be divided into:

  1. Positive consumption externalities
  2. Positive production externalities

If consumption of certain products and services by an individual benefits other people, it would be referred to as a positive consumption externality. Similarly, if the benefit to third party is brought about by production of certain goods, it would be referred to as a positive production externality.

Examples of positive consumption externalities

  • Immunization

Building immunity by getting vaccinations for particular diseases, like the COVID-19 would not only prevent the recurrence of the viral disease in the person, but would also benefit other individuals who interact with the person. This would, in turn, prevent the third party from falling ill and going out of work.

  • Education

A person’s investment in self-education may benefit him – in advancing his professional career – his employer, and consequently result in economic development of the country s/he resides in.

Examples of positive production externalities

  • Public transport

The development of a transport system that connects a distant area to the city center would not only help the transport company to earn, but it would also benefit the real-estate agents in that area, as more people will prefer to live there, thus giving an opportunity to real-estate owners to earn more.

  • Research and Development

Even though investment in research and development activities may directly help the specific company to generate more money by producing a better product, it will ultimately benefit society as a whole. For instance, if a pharmaceutical company develops a vaccine for the COVID-19, it would not only benefit the company or those who receive the shot but would also benefit other individuals (third party) by controlling the spread and ultimately reviving the economic activity.

Now that you have understood each subtype with multiple examples of externalities, let’s discuss the impact of these externalities on market equilibrium.

Impact of externalities on market equilibrium

In economics, externalities are considered to be a cause of market failure. Reason being that they create inefficiencies and disrupt the equilibrium of the market.

Basically, market equilibrium refers to the perfect balance between benefits of a purchase that are enjoyed by the buyer and the price that the seller has charged for it. However, externalities result in the distribution of these costs and benefits to third party which means that the price charged or paid for a product does not account for the true value of the goods or services.

As we understood via examples of externalities, that some costs are borne by third party in case of negative externalities. If the producer would have been made to pay those costs, the quantity of production would have been much lower.

Similarly, in the case of positive consumption externalities, if the buyer would have been receiving all the benefits rather than some being shared with a third party, the demand of the particular product or service would have increased.

Solution to externalities

Even though externalities cannot be completely eliminated, their effect can be minimized if the state implements certain policies, including but not limited to, charging taxes, imposing fines or establishing regulations to combat negative externalities such as the release of harmful chemicals into air and water.

This would make up for the costs transferred to the third party. Similarly, activities that support market equilibrium can be promoted by offering subsidies and rewards.

It is important that authorities take measures to counter the impact of externalities. Otherwise, the world would face a situation similar to Tragedy of the Commons where everyone’s priority would be to benefit from the available (limited) resources without making any effort to contribute. As a result, there would be an over-consumption which would ultimately leave nothing for anyone.

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