How is your dog related your neighbor’s education? How does pollution from a nearby factory affect your health? When an individual, government or private company engages in a mega project, it may cause unintended costs and benefits to other people. The indirect effect of an activity to a society can have negative or positive outcome on others.
What is the definition of an externality?
The word externality emerges from the Latin word “externus”, which means “outside”. It is therefore an outward effect of something.
In economics, an externality refers to a cost or benefit experienced by a third party. Externalities are often not added to the eventual benefits or costs of an activity because they do not directly affect the transaction.
When markets are working well, the costs and benefits of a good or service are absorbed by those who are directly involved in the transaction. For example, if you buy a pen to write your school notes, you incur the cost price of the pen and gain the benefit of improving your knowledge. However, the benefits or cost of a transaction may sometimes be enjoyed or incurred by a third party who is not directly involved in the transaction.
The spillover of costs and benefits of a transaction to third parties is known as an externality.
A negative externality occurs when the cost of a transaction spills over to a third party. Negative externalities are the costs incurred by third parties from a transaction or economic activity. They often occur when a business creates costs that are borne by society or the environment. These externalities are imposed on a third party without their knowledge, and they have negative consequences on the affected person or entity. Such consequences are never compensated for.
Examples of Negative Externalities
One of the examples of negative externalities is pollution. Let us say you live in a neighborhood with few people. The environment is serene and calm. Then a factory is built just in the opposite alley. They start running heavy machines and trucks which produce a lot of noise. This results in noise pollution, which causes negative externality to you as a third party.
Another example is air pollution which occurs when many people buy cars. Such products emit gases to the environment, leading to the depletion of the ozone layer. This causes climate change which affects communities and the environment.
When you buy a dog, it gives you security. But when it starts to bark all night while your neighbor is studying, it causes a negative externality. The neighbor may not understand what he or she is studying due to high level of noise caused by your dog. This means that your dog affects your neighbor’s education negatively – negative externality.
How to Address Negative Externalities
The government can help in reducing negative externalities through taxation. When an economic activity creates costs for communities, the government may impose taxes to discourage such activities. Pollution tax occurs when a company is taxed for every unit of pollution they cause. It is only through taxation that the spillover costs of a transaction can be incorporated into the activities of the polluting entity. Taxation ensures that the producer pays for the full cost of production, including the spillover costs to third parties. The use of taxation to deal with negative externalities is referred to as internalizing externalities.
For instance, assume a manufacturer of steel incurs direct production cost of $5 per unit of steel and shifts a total cost of $1 to neighboring community through a negative externality. The government might tax this company $1 on each unit of steel produced, leading to a total production cost of $6. As a result of the higher cost of production, the firm will reduce the level of pollution in order to minimize the costs of production.
A neighbor whose barking dog is causing sleepless nights for the neighbors may be fined as a corrective measure to address the negative externality.
Positive externalities occur when a third party benefits from an economic transaction that they are not directly engaged in. For instance, if a company establishes a factory within a neighborhood and decides to build a road leading to the factory, people living within the area will benefit from the new road network even if they did not participate in its construction.
Examples of Positive Externalities:
- The use of software in a business leads to positive externalities to consumers through increased efficiency and reduced product prices.
- Street lights established by government to address insecurity in an area will benefit businesses who are able to sell more products at night.
- Education to members of a community leads to increased employment opportunities and reduced involvement in crime, which benefits all members of society.
- The construction of roads and new government offices within a neighborhood may increase the value of property. This creates positive externalities for land owners in the neighborhood.
How to Encourage Positive Externalities
Positive externalities can be encourage through government subsidies which are extended to goods or services that create positive spillovers. A subsidy is a payment made by government to individuals or firms to lower the cost of producing a good or service. Providing a subsidy encourages a business to increase the production of goods and services that create positive externalities.