Externalities

Definition

In Economics, an “Externality” is a benefit or cost that is not reflected in the price of a good or service.

Why do Externalities Exist?

Prices are determined by the relationship between the supply and demand of a good or service (for details, see our article on Supply and Demand Examples in the Stock Market). This, in turn, is determined by individual producers and consumers.

Negative Externalities

PollutionIn come cases, the direct producers and consumers are not the only ones who are impacted by a good being produced or consumed. Pollution is a good example – if a company dumps toxic waste in a local river as part of its production process, the price of cleaning it up is not reflected in their production cost.

If the full costs of cleaning up the pollution were reflected in the price, less of this good would be produced. From a societal standpoint, there is a surplus.

 

Positive Externalities

On the other hand, if a person wants to install a solar panel to their house, the total pollution put out by the electric companies is reduced. This means the air quality is higher and the entire public in the area benefits, but this benefit is not reflected in the cost of the solar panel.

If the full benefits of the solar panels were reflected in the price, more solar panels would be produced and installed. From a societal standpoint, there is a shortage.

Correcting Externalities

Governments and economies do recognize that externalities exist, and some actions are taken to account for them.

Taxes and Subsidies

Taxes and subsidies are used to try to directly add these costs and benefits directly to the products.

Economics In Action!
Punitive taxes are also used on tobacco to discourage people from smoking!
Punitive taxes are applied to goods that produce a lot of pollution, with the tax itself causing the price to go up and less to be produced/consumed, while the revenue is used to help clean up the pollution.

Subsidies are also applied to products like solar panels – the government will usually pay back the percentage of the cost of solar panels if you buy and install them on your home to help reflect the extra benefits it brings.

Quotas

If taxes and subsidies are not enough, governments can also put in place quotas, which are strict limits on how much of a good can be produced or consumed. One of the most common examples is hunting permits – people need to buy a permit to hunt, and even then they can only hunt a certain number of animals. Commercial fishers are also restricted in how many fish they are allowed to catch per season.

Both of these restrictions exist to allow animal populations to recover. That way, even if the market price for fish increases rapidly, fishing companies are still restricted in how many they can catch at a time.

Problems with Government Correction

While the government can put these restrictions in place, there is always a limit to how much can be done, and so some laws and regulations are prioritized over others.

When politicians need to choose which regulations to pass, there is a general trend to favor things that have a very large positive impact on a smaller group of influential people, at the expense of a smaller negative impact on a wider group of people.

This happens because when the negative impact is spread wide enough, most people might not even notice it at all, but the total impact on society can sometimes be worse than if there was no intervention at all.

What Does This Mean For Me?

None of these restrictions are perfect, and so each person should keep in mind the externalities, and what extra taxes, subsidies, and quotas are associated with them.

If something you want to consume has negative externalities, they are almost certainly not completely offset by any punitive taxes, so you should try to research alternatives and consider their full cost.

If there are positive externalities, it may be difficult to find information on any subsidies that might be available to you, since they can vary widely by state. If you have a more expensive alternative available for something you want to buy or use, always check to see if there are any programs available that might help offset the cost.

One starting point for your search is the Energy.Gov website, which lists many programs by state.

Pop Quiz

If reading this article was an Assignment, get all 3 of these questions right to get credit!

Click "Next Question" to start the quiz!

1 of 3) Why do externalities exist?
2 of 3) What is the overall impact on a society for a good that has negative externalities?
3 of 3) Why do politically-powerful groups get bigger positive impacts of externalities?

We have received your answers, click "Submit" below to get your score!