Externalities: It’s What Pandemics, Pollution and Puppies Have in Common

June 02, 2021

A lot of attention has been given lately to wearing masks and social distancing since we are, after all, in the midst of a pandemic. But what does a pandemic have in common with pollution—or puppies?

Pandemics, pollution and puppies, as well as education and well-manicured lawns, help explain the economic concept of externalities.

From an economic perspective, externalities are costs and benefits that impact someone other than the producer or the consumer of a good or a service.

  • Externalities that place a cost on someone, on a community or on society as whole are known as “negative externalities.” Put another way, a negative externality happens when a cost, or burden, “spills over” to a third party. Pollution is an example of a negative externality.
  • Externalities that provide a benefit to others are “positive externalities.” Education, for example, generates positive externalities.
  • Not all goods and services come with externalities, but many do—and some that do might be a surprise.

Let’s dig into the details and look at some examples.

What Makes Pollution a Negative Externality?

In the Economic Lowdown series video “Externalities,” Scott Wolla explains what makes pollution a negative externality. Wolla is a Federal Reserve Bank of St. Louis economic education coordinator.

Wolla talks about a factory that produces widgets and has smokestacks that belch out pollution 24/7. Even those who don’t buy any widgets breathe the polluted air. Thus, the factory is shifting some of the production costs to society.

“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,” Wolla explains.

“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.”

Other negative externalities occur from a puppy that barks all the time and a radio blaring in the middle of the night—there’s seemingly nothing beneficial about either of those for the neighbors. We’ll see later that in some circumstances a barking puppy can create a positive externality, however.

Education Generates Positive Externalities

In his video, Wolla explains how education produces positive externalities: The benefits don’t only go to the person getting the education, but also “spill over to society in general,” Wolla says.

“For example, well-educated citizens are more likely to make good decisions when electing leaders,” he says. “In addition, more education leads to higher worker productivity and higher living standards for society in general.”

Other positive externalities are generated by a neighbor’s puppy that only barks at strangers and a neighbor’s lawn that’s beautifully landscaped. People can enjoy the benefits—a warning system or a nice view—without encountering a cost.

What Does a Pandemic Have to Do with Externalities?

In a December 2020 Regional Economist article, economist and Research Officer Guillaume Vandenbroucke explains that a “lack of social distancing by one person during the pandemic creates an externality: a higher risk of infection for all.” He further explains that understanding externalities helps us understand the policy debate surrounding the COVID-19 pandemic and government’s role in externalities.

Negative externalities can be corrected with some help from the government, Wolla says.

“Government can discourage negative externalities by taxing goods and services that generate spillover costs,” Wolla says.

On the other side of the coin: “Government can encourage positive externalities by subsidizing goods and services that generate spillover benefits,” he says.

Vandenbrouke gives an example in the case of the pandemic. “Society could pay the infectious person to stay at home,” he says. “This could take the form of compensations such as unemployment benefits for those who could not go to work.”

So the next time you take your puppy for a walk past that beautiful neighborhood lawn, or notice a smokestack belching pollution into the air, you’ll know that you’re seeing examples of externalities.

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About the Author
Headshot of Sharon Van Stratton
Sharon Van Stratton

Sharon Van Stratton is a senior web content strategist with the St. Louis Fed External Engagement and Corporate Communications Division.

Headshot of Sharon Van Stratton
Sharon Van Stratton

Sharon Van Stratton is a senior web content strategist with the St. Louis Fed External Engagement and Corporate Communications Division.

This blog explains everyday economics, explores consumer topics and answers Fed FAQs. It also spotlights the people and programs that make the St. Louis Fed central to America’s economy. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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