An externality occurs in economics when a decision (for example, to pollute the atmosphere) causes costs or benefits to individuals or groups other than the person making the decision. In other words, the decision-maker does not bear all of the costs or reap all of the gains from his action. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society. If the world around the person making the decision benefits more than he does (education, safety), then the good will be underconsumed by individual decision makers; if the costs to the world exceed the costs to the individual making the choice (pollution, crime) then the good will be overconsumed from society's point of view.
To most economists, the problem of an externality usually concerns the results of market activity. Economists see voluntary exchange as mutually beneficial to both parties in an exchange. On the other hand, either the consumption of a product (perfume, nice clothes) or its production may have external effects -- as in the diagram. Those who suffer from external costs do so involuntarily, while those who enjoy from external benefits do so for free. The left-hand-side of the diagram shows consumption externalities (such as those of perfume), while the right-hand-side shows production externalities (such as those produced by a perfume factory).
From the perspective of a social planner or welfare economics, this will result in an outcome that is not socially optimal. From the perspective of anybody affected by the externality, it is either a negative factor in their lives (as with obnoxious perfume or pollution) or a boon (as with the other's pretty clothes). In the first case, the person who is affected by the negative externality (air pollution) will likely see it as violating his freedom to breathe freely. It might even be seen as trespassing on their lungs, violating their property rights. Thus, an external cost can easily pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights. An external benefit, on the other hand, may increase the availability of choices for -- and thus the amount of freedom of -- the beneficiaries with no cost to them. (In effect, it's a "free lunch" for them.) They may thus resist the ending of such beneficial externalities along with any associated inefficiencies.
The value of the effects of the externality are likely not something that can be easily calculated in a technocratic way by economists or social planners, since they reflect the ethical views and preferences of the entire population. Instead, for countries believing in popular sovereignty, some sort of democratic method is needed to attach values to the external costs and benefits.
Sometimes, laissez-faire economists such as Friedrich von Hayek and Milton Friedman refer to externalities as "neighborhood effects " or "spillovers". But it should not be thought that all externalities are small, spilling over only in the "neighborhood." For example, some claim that the burning of fossil fuels affects the entire "neighborhood" of the Earth, encouraging global warming.
Going outside the broadly-defined liberal political tradition, Marxists see externalities of all sorts (including pecuniary ones – see below) as ubiquitous, the rule rather than the exception. Production is "socialized" or totally interdependent. On the other hand, under capitalism, property rights, the appropriation of income, and the making of economic decisions are largely individualized. In order to solve this "contradiction" between socialized production and individual decision-making, Marxists often call for democratic economic planning, as a key part of socialism.(cf. Frederick Engels, "Socialism: Utopian and Scientific")
Types of externalities
Examples of these kinds of externalities include:
- Pollution by a firm in the course of its production which causes nuisance or harm to others. This is an example of a negative externality, external cost, or external diseconomy.
- The harvesting by one fishing company in the open sea depletes the stock of available fish for the other companies. Over-fishing may result. This is an example of a common property resource, sometimes referred to as the Tragedy of the commons.
- An individual planting an attractive garden in front of his house may benefit others living in the area. This is an example of a positive externality, beneficial externality, external benefit, or external economy. Goods with positive externalities are known as Merit goods.
- An individual buying a picture-phone for the first time will increase the usefulness of such phones to people who might want to call him or her. This may lead to the general acceptance of these phones. This is an example of a network externality.
- A property tycoon buying up a large number of houses in a town, causing prices to rise and therefore making other people who want to buy the houses worse off (perhaps by excluding them from the housing market), is not causing an externality, because the effect is through prices, and is considered part of the normal functioning of the market. Alternatively, these effects are sometimes called "pecuniary externalities", with externalities as defined above called "technological externalities." This article considers only the latter.
Externalities are important in economics because they may lead to inefficiency (see Pareto efficiency). Because the producers of externalities do not have an incentive to take into account the effect of their actions on others, the outcome will be inefficient. There will be too much activity that causes negative externalities such as pollution, and not enough activity that creates positive externalities, relative to an optimal outcome. As noted, external costs also can imply political conflicts, rancorous lawsuits, and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle.
Many of the most important externalities in the economy are concerned with pollution and the environment. See the article on environmental economics for more discussion of externalities and how they may be addressed in the context of environmental issues.
Externalities in supply and demand
The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be monetized (valued in terms of money). An extra supply or demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers pay as individuals for additional quantities of the good (in competitive markets, the marginal private cost) and the other curve is the true cost that society as a whole pays for production and consumption of increased production the good (the marginal social cost).
Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demand in the market.
The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under laissez-faire). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of the smoking stacks and water pollution. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.
If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the social benefit is less than the societal cost, so society as a whole would be better off if the goods between Qp and Qs had not been produced. The problem is that people are buying and consuming too much steel.
This discussion implies that pollution is more than merely an ethical problem; it is more than just "greedy" (profit-maximizing) firms. The problem is one of the disjuncture between marginal and social costs that is not solved by the free market. There is a problem of societal communication and coordination to balance benefits and costs. This discussion also implies that pollution is not something solved by competitive markets. In fact, a monopoly might be able to use some of its excess profits to be benevolent and internalize the externality (pay the cost of the pollution). More likely, a monopoly would artificially restrict the quantity supplied in order to maximize profits. This would actually benefit society in this situation because it would mean less pollution than in the competitive case. Perfectly competitive firms have no choice but to produce according to market incentives (private costs): if one decides to internalize external costs, it implies higher costs than those of competitors and likely exit from the market. So some collective solution is needed, e.g., government intervention banning or discouraging pollution, or an alternative economy such as participatory economics.
The graph below shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the vaccination is less than the marginal social or public benefit by the amount of the external benefit, i.e., the fact that if one person gets the vaccination, others are less likely to get the smallpox even if they themselves are not vaccinated. This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume that there are no external costs, so that social cost equals individual cost.
If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be better off if more goods had been produced. The problem is that people are buying too few vaccinations.
The issue of external benefits is related to that of public goods, i.e., goods where it is difficult if not impossible to exclude people from benefits. The production of a public good has beneficial externalities for all (or almost all) of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefits and costs. This also implies that pollution is not something solved by competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government does this, the good is called a merit good.
Externalities and the Coase theorem
Ronald Coase argued that individuals could organise bargains so as to bring about an efficient outcome and eliminate externalities without government intervention. The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the "Coase Theorem," requires that
- Property rights are well defined;
- the number of people involved is small; and
- bargaining costs are very small.
Only if all three of these apply will individual bargaining solve the problem of externalities.
Thus, this theorem does not apply to the steel industry case discussed above. For example, with a steel factory that trespasses on the lungs of a large number of individuals with its pollution, it is difficult if not impossible for any one person to negotiate to be compensated for this transgression. It may extremely expensive even for all individuals to negotiate with the steel firm, especially since some individuals may be tempted to be "free riders," benefiting from the negotiations without paying any costs. Thus, most economists see the need for government to be involved with big external costs, to regulate the firm while paying for the regulation with taxes.
The case of the vaccinations also does not fit with the Coase Theorem. The firms of the vaccination industry would have to get together to bribe large numbers of people to have their shots. Individual firms would be tempted to "free ride" and not pay the cost of these bribes. In many cases, it is simpler to involve the government.
This does not say that the Coase theorem is totally irrelevant. For example, if a logger is planning to clear-cut a forest in a way that has a negative impact on the nearby resort, it is quite possible that the resort-owner and the logger could get together to agree to a deal. For example, the resort-owner could pay the logger not to clear-cut -- or could buy the forest. In terms of the examples that started this entry, telling someone that her perfume is offensive may easily lead to its being replaced, while praising the clothes of the fancy dresser may encourage the wearing of similar clothes in the future. Of course, none of these bargains may work out as well as desired.
Also, the central government may not be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically-run communities can agree to deal with these costs and benefits in an amicable way.