written by | October 26, 2022

What is the Meaning of Externality in Economics? See Types and Causes

×

Table of Content


An externality is a cost or benefit that affects a third-party who didn’t choose to incur that cost or benefit. In other words, it is an external cost to a third-party individual or a firm because they did not willingly choose to incur it. An externality can be positive or negative. A positive externality is when a third-party benefits from the consumption and production of a product. It is when consumption of good has positive effects on third parties who are not directly consuming the good in question. An example of this could be if eating red peppers has health benefits for others through secondhand exposure, such an example of a negative externality is also known as a social cost. It is when consumption of a good has negative consequences on third parties who are not directly consuming the good in question. An example of this could be if eating red peppers causes allergic reactions in others through secondhand exposure, such as dining in the same restaurant. Keep reading to find out more about how economists identify and measure externalities and their implications for society and public policy.

Did you know? Negative externalities can impact society and businesses, and some negative externalities can cause business failures.  

Also read: Guide To Start Computer Repair Shop In India - Computer Repair Shop Business Plan

What is an Externality?

An externality is said to occur when the manufacturing and consumption of a product or service has an effect on the third-party, which plays no role in the manufacturing or consumption of the same. For example, we say an externality is negative when it impacts the third-party or society indirectly. Like, when the pollution caused by a factory directly impacts the neighbouring households. Whereas, a positive externality is when the production or consumption of a product or service affects an organisation or society as a whole. 

An  example for externalities would be a factory polluting environment that creates a cost to society but costs are not priced within the final good it produces.

What are the Types of Externalities?

There are three types of externalities:

1. Negative Externalities 

Negative externalities are costs or losses that affect others, but not the party responsible for them. They are caused by the actions of one party without regard for the effects that may be felt by other people.

One form of negative externality is pollution. This type of external cost can be reduced by making polluters pay their share, through taxes on pollution-causing industries, price caps on harmful chemicals, or other mechanisms. Another form of negative externality is traffic congestion. While driving in rush hour traffic is unpleasant and frustrating, it also causes massive amounts of wasted time and fuel consumption. If commuters could carpool during rush hour instead of driving alone, this would reduce congestion and its associated costs.

2. Positive Externalities

A positive externality occurs when increased by a given collective action, such as government intervention or charity. Positive externalities occur when the benefits of a collective action exceed its costs. For example, if everyone in a community passed out on the way to an important meeting, it would be much easier for them to arrive and much less time would be wasted waiting for others to get there. In this case, the benefit of everyone’s passing out would outweigh the cost of one person missing the meeting.

To see why this is a good thing, imagine that the action that benefits everyone cost 8,267.25 and only raised 6,227.29 overall. If negative externalities also occurred in that case, we could say that the positive externality was worth  ₹2075.76. This positive externality is what makes other people more likely to engage in similar actions and has been referred to as Social Return on Investment (SROI).

When there are positive externalities, it is often possible to improve welfare while reducing costs. For example, by investing small amounts of money in nonprofits that help those with drug addictions, we can prevent many people from suffering significant health issues and reduce overall healthcare costs.

Also read: Business without Investment: Effective Ways to Start a Business with Zero Investment

3. Existence Externalities: Externality caused by the mere fact that a good exists

Existence externalities are the effects of the mere fact that a good or service exists. Two common examples of existence externalities are environmental damage and traffic congestion, both of which cause negative externalities for nearby citizens.

Creating an externality occurs when a good has non-marketable benefits, such as reduced pollution levels or a more efficient public transportation system, while not being fully compensated by the market. A good that produces negative externalities is known as a public good and will always have free riders (people who benefit from the free goods) and those who pay for its production. This can lead to a situation where people begin to overuse the public good causing it to deteriorate. Traffic congestion is one example of this, with a reduction in road space leading to increased traffic flow even though roads could be built without that effect occurring. The solution to this is either to charge users for using the road (a toll road), or providing incentives for people to leave work earlier.

Cost of Existing Markets with Externalities

Traditional economic models assume that markets produce an efficient outcome. However, theory and research shows that markets produce inefficient outcomes in cases where there are externalities. In these cases, a market will produce too much of the good with a positive externality and too little of the good with a negative externality. For example, a factory produces pollution that harms the health of the community surrounding the factory. The pollution is a negative externality. The factory owners do not take into account the negative health effects of the pollution when deciding how much to produce, so they produce more than is socially optimal. This means that the market price of pollution is less than the social cost of pollution.

What Causes Externality?

An externality is a cost or benefit that affects a party who did not choose to incur that cost or benefit. In other words, the cost is external to the individual because they did not willingly choose to incur it. An externality can be positive or negative. A positive externality is also known as a social benefit. It is when consumption of a good has positive effects on third parties who are not directly consuming the good in question. Firms could cause externalities while producing goods which would be sold in the market. It is known as production externalities. Individuals can also produce externalities when consuming goods.

Measuring Externalities in Economy

When economists decide whether a good has an externality, they try to measure the costs and benefits associated with the good. They use measuring tools such as cost-benefit analysis, cost-effectiveness analysis, and cost-utility analysis. These tools help economists measure the benefits and costs associated with a good, such as the pollution from a factory. Economists can use this information to decide whether the market’s outcome is efficient or inefficient. They can also use the information to decide the best policy to use in response to the externality.

Public Policy to Deal with Externalities

Governments can respond to externalities using taxes, subsidies, and regulations. Taxes are a fee on a good to increase its price, which leads consumers to reduce their consumption of the good and producers to increase their production of the good. Subsidies are a government payment that lowers the price of a good and encourages consumers to consume more of the good and producers to produce less of the good. Regulations are laws that force individuals to reduce their consumption of a good or force producers to increase their production of a good.

Also read: Top 9 Crowdfunding Platforms In India For Business 2022

Conclusion

In the first part of this article, we examined the concept of externality in economics. We found that each agent in an economic system is subject to constraints by their position in the system. In the second part, we examined the types of externalities. Externalities, unlike internalities, involve actions taken by third parties that have a negative or positive impact on other agents in the system. We found that the impact of externalities can be both positive and negative. The question then becomes, how do externalities come about, and why do they exist?

The answer to these questions is that actions taken by one party in an economic system have effects that are not accounted for by the other parties. This is a classic example of externality. 
Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: What are positive externalities?

Ans:

A positive externality exists when a benefit spills over to a third-party. An example of a positive externality in consumption is using a bicycle or walking to work rather than use a vehicle.

Q: Why are externalities important?

Ans:

Externalities affect resource allocation because the market fails to fully price the external effects generated by some economic activities.

Q: Is externality positive or negative?

Ans:

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.

Q: What is an example of an externality?

Ans:

An example of externality can be a factory that pollutes the environment and creates a cost to society, but those costs are not priced into the final good it produces.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
×

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.