Externalities Highlighted Sections What is an externality? Production Externalities Consumption Externalities Private Solutions Public Solutions What is an externality? - (Back to Top) An externality is "the impact of one person's actions on the well-being of a bystander". So whenever the actions of a buyer and/or a seller affect a third party (who is neither the buyer or seller - therefore, the third party is "external" to the market transaction) there is an externality.   As an example, suppose that you buy gas for your car from a gas station. When you drive your car, you cause pollution. Your next door neighbor has to breathe polluted air because you purchased gas from the gas station. Your neighbor is the third party in this transaction (your neighbor neither bought or sold the gas) but is affected by the transaction between you and the gas station. Therefore, the pollution from your car is an externality.   During the next two sections, you will work through 4 examples that illustrate the different ways the impact of externalities can be felt. It is important that you realize (in all 4 examples) that an externality is always the same thing - the impact of one person's actions on the well-being of a bystander. There are just different ways the impact is felt. In other words, you are NOT learning 4 different models here - you're learning ONE model that has various possibilities.   Before proceeding with your study of externalities, make sure you understand the answer to the following question:   Q: If there is an externality in a market, what happens? A: The market will malfunction, and the quantity of the product traded in the market will NOT be equal to the socially optimal quantity.   The reason externalities produce a quantity traded that is NOT socially optimal is that externalities involve some UNMEASURED cost or benefit in the marketplace. In the previous example involving gasoline and pollution, the cost imposed on your neighbor of having to breathe polluted air is unmeasured.   In the next 4 examples, you will see that externalities can derive either from the production or consumption of a product, AND that the effects of externalities can be either positive or negative. Production Externalities - (Back to Top) Java Powered! Negative production externalities - In the figure at right, click on "production" and move the slider to the left, so that the figure depicts a negative production externality. An example of a negative production externality is oil refining. Before gas can be burned in your car, the crude oil must be refined. The process of refining crude oil creates air pollution. This pollution, when breathed by third parties, has harmful effects - therefore, we have a negative production externality.   In the figure at right, notice that the negative production externality causes the social cost to be higher than the private cost. Let's review this terminology for a minute: private cost is the cost of production that is actually measured by the free market; social cost is the "true" cost of production, if we could include ALL relevant costs (in this case, including the cost of the pollution). Notice also that the vertical distance between social cost and private cost IS the cost of the pollution.   Q: What is the effect of a negative production externality? A: The quantity of gas actually produced by the market (Qmarket) is greater than the socially optimal quantity of gas (Qoptimum). The result is that a negative production externality causes the product in question (gas) to be OVERPRODUCED! Java Powered! Positive production externalities - In the figure at right, click on "production" and move the slider to the right, so that the figure depicts a positive production externality. An example of a positive production externality is the effects of technological improvements. Often, improvements in technological know-how affect not only the initial product being produced, but also these improvements spillover into the production of other goods.   Q: What is the effect of a positive production externality? A: The social (or TRUE) cost of producing a product is actually LOWER than the private cost (as measured by the market). Therefore, the product is UNDER PRODUCED by a free market. You can see this in the figure where Qmarket is less than Qoptimum. Consumption Externalities - (Back to Top) Java Powered! Negative consumption externalities - In the figure at right, click on "consumption" and move the slider to the left, so that the figure depicts a negative consumption externality. Alcohol is an example of a product that might have a negative consumption externality. When people drink and drive, and cause harm to others as a result, then the "true" value of consuming alcohol is less than the value determined by the market (in other words, the social value lies below the private value).   Q: What is the effect of a negative consumption externality? A: The quantity of alcohol actually produced by the market (Qmarket) is greater than the socially optimal quantity of alcohol (Qoptimum). The result is that a negative consumption externality causes alcohol to be OVERPRODUCED! Java Powered! Positive consumption externalities - In the figure at right, click on "consumption" and move the slider to the right, so that the figure depicts a positive consumption externality. An example of a positive consumption externality is flu shots. Most people value flu shots because they are less likely to contract the flu after receiving the shot. However, if people don't contract the flu because of the shot, then they also don't pass the flu on to others later on. Therefore, there is an unmeasured benefit (or a positive consumption externality) to getting flu shots.   Q: What is the effect of a positive consumption externality? A: The social (or TRUE) benefit of consuming a flu shot is actually GREATER than the private value (as measured by the market). Therefore, flu shots are UNDER PRODUCED by a free market. You can see this in the figure where Qmarket is less than Qoptimum. Private Solutions - (Back to Top) Different types of private solutions   Moral suasion - People are taught that activities which create externalities are "bad". Because of this moral pressure, the externality may be eliminated. An example here is that people are taught at an early age NOT to litter - therefore, most people don't litter. Charities - People can give private donations to charities, whose actions correct for externalities. Donations to college endowment associations (that help fund higher education) is an example. Mutual self interest - Sometimes people find working together to be mutually beneficial, and their combined actions will eliminate an externality that would otherwise exist. Private contracts - If mutual self interest does not solve the problem, people can enter into legal agreements that force themselves to act in a way that deals with an externality. Public Solutions - (Back to Top) Types of Public Solutions   Regulations - The government can choose to simply set rules for the amount of pollution that apply to each individual in the market. This can include the option for the government to simply outlaw some activity (like dumping toxic waste into a river).   Pigovian taxes and subsidies - The government can allow people to pollute, but the government will tax the polluters based on the amount of pollution that people create. In this case, the government simply puts a price on the right to pollute. Based on the demand for people to pollute (a factor has a demand to pollute if it has a reason to produce a product that causes pollution in the first place), this will determine the quantity of pollution that will actually occur. A Pigovian tax is illustrated in the figure below, on the left.   A Pigovian tax is appropriate any time there is a negative externality (whether in production or consumption). If there is a positive externality, the government could opt for a subsidy instead (a subsidy is just the opposite of a tax - if you have to pay a tax in order to do something, then the government pays YOU a subsidy every time you do something).   Tradeable pollution permits - Another option is for the government to decide how much pollution is acceptable. Once this is accomplished, the government can sell off permits that allow the purchaser to pollute a certain amount. This time, the demand for people to pollute determines the price of pollution (notice how this is the opposite of the Pigovian tax...where the government set the price of pollution and the market determined the quantity). In the figure below, the right graph depicts a market for tradeable pollution permits. Notice how the permits (on the right) and the Pigovian tax (on the left) lead to the same price and quantity for pollution! (Back to top)