Externalities - The Economic Lowdown Video Series

Hi, I’m Scott Wolla.

What do pollution, education and your neighbor’s dog have in common?

No, that’s not a trick question.

All three are actually examples of economic transactions that include externalities.

When markets are functioning well, then all the costs and benefits of a transaction for a good or service are absorbed by the buyer and seller.

For example, when you buy a doughnut at the store, it’s reasonable to assume all the costs and benefits of the transaction are contained between the seller and you, the buyer.

However, sometimes, costs or benefits may spill over to a third party not directly involved in the transaction.

These spillover costs and benefits are called externalities.

A negative externality occurs when a cost spills over.

A positive externality occurs when a benefit spills over.

So, externalities occur when some of the costs or benefits of a transaction fall on someone other than the producer or the consumer.

Negative Externalities

Imagine there’s a factory in your town that produces widgets, a good that benefits consumers all over the world.

The smokestacks at the factory, however, belch out pollution 24/7.

From an economic perspective, the firm is shifting some of its cost of production to society.

How? Well, in its production process, the firm uses clean air—a resource it does not pay for—and returns polluted air to the atmosphere, which creates a potential health risk to anyone who breathes it.

If the firm were paying the full cost of production, it would return clean air to the atmosphere.

Instead, if society wants clean air, society must pay to clean it.

So, in this case, pollution represents the shifting of some of the cost of production to society, a negative externality.

And, because the firm isn’t paying the full cost of producing widgets, the price charged for widgets is artificially low. Consumers will buy more widgets at the artificially low price than at a price that reflects their full production cost.

So, ultimately, more widgets are produced than would be the case if all costs were included.

And, since more widgets are being produced, more air is being polluted.

Correcting Negative Externalities

Government can play a role in reducing negative externalities by taxing goods when their production generates spillover costs.

This taxation effectively increases the cost of producing such goods.

The higher costs better reflect the true cost of production because it includes the spillover costs of pollution.

So, such taxation attempts to make the producer pay a cost that reflects the full cost of production.

The use of such a tax is called internalizing the externality.

For example, let’s assume the cost of producing widgets is two dollars per unit, but an additional 20 cents per unit had been shifted to society as a negative externality in the form of dirty air.

The government could place a 20 cent tax on each widget produced to ensure that the firm pays the actual cost of production—which is now two dollars and twenty cents, including the cost of the negative externality.

As a result of the higher cost of production, the firm will reduce its production of widgets thus reducing the level of pollution.

Positive Externalities

When you complete some post-high school training, you'll reap the benefits of your education in the form of better job opportunities, higher productivity and higher income.

A technical degree or college education will further enhance those benefits.

Although you might think you are the only one who benefits from your education, that isn’t the case.

The many benefits of your education spill over to society in general.

In other words, you can generate positive externalities.

For example, well-educated citizens are more likely to make good decisions when electing leaders.

In addition, more education leads to higher worker productivity and higher living standards for society in general.

Although education has many spillover benefits, providers of education do not receive the revenue they would earn if the full benefits of the transaction were internalized.

To state it differently, producers of education are not fully compensated for the benefits that spill over to society.

As a result, producers of education will likely under-produce education.

Encouraging Positive Externalities

Government can play a role in encouraging positive externalities by providing subsidies for goods or services that generate spillover benefits.

A government subsidy is a payment that effectively lowers the cost of producing a given good or service. Such subsidies provide an incentive for firms to increase the production of goods that provide positive externalities.

And, because the spillover benefits go to society, government subsidies are a way for society to share in the cost of generating positive externalities.

After all, society pays the taxes that fund the subsidies.

Regarding education, because the government subsidizes public education, a greater quantity of education is produced and consumed and society reaps the spillover benefits.

To summarize, the costs and benefits of transactions for goods and services are often contained between the producers and consumers, but sometimes costs and benefits spill over to third parties.

A negative externality exists when a cost spills over to a third party.

A positive externality exists when a benefit spills over to a third party.

Government can discourage negative externalities by taxing goods and services that generate spillover costs.

Government can encourage positive externalities by subsidizing goods and services that generate spillover benefits.