Externalities Adam Smith's 'invisible hand' which pushes the market towards efficiency does so under the assumption that all buyers and sellers are self-interested. However, it cannot make up for costs or benefits resulting from the production of products, or their consumption, which affect people other than the buyer and seller. Such costs and benefits are called externalities.
An externality is a cost or benefit that arises from the production or consumption of a private good and that falls on someone other than its producer or consumer. Externalities arise when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect. A negative externality has an adverse impact on the by-stander, and a positive externality has a beneficial impact. |
Negative Externalities
Most externalities that come to mind are negative ones. It is obvious that self-interested buyers and sellers can have negative impacts on those around them. Some examples of negative externalities are:
· Theft - Besides the obvious impact on the victim, theft can lead to rises in insurance premiums, and in the case of house burglaries a possible decrease in house prices in the area
· Air pollution - Pollution is known to have serious effects on health, and due it's nature air pollution cannot be restraint so as to only effect those who cause it
· Driving under the influence of alcohol - Driving alone is associated with a lot of externalities - traffic congestion, pollution and danger to cyclists and pedestrians. Driving after drinking seriously increases this danger.
· Theft - Besides the obvious impact on the victim, theft can lead to rises in insurance premiums, and in the case of house burglaries a possible decrease in house prices in the area
· Air pollution - Pollution is known to have serious effects on health, and due it's nature air pollution cannot be restraint so as to only effect those who cause it
· Driving under the influence of alcohol - Driving alone is associated with a lot of externalities - traffic congestion, pollution and danger to cyclists and pedestrians. Driving after drinking seriously increases this danger.
Positive Externalities
Positive externalities are the other side of the coin. They are the beneficial side effects that happen largely without the intent of the self-interested agents. Some examples are as follows:
- Vaccinations - While the point of vaccinations is to immunize oneself against infection, by doing so a person inadvertently reduces the possible number of carriers of the infection, thus reducing the risk of the sickness to others
- Education - By going through the education system you can increase your future standard of living, but an educated workforce strongly benefits a country's economy also
- Technology Spillover - This is when a firm’s innovation or design not only benefits the firm, but benefits society as a whole. This occurs in the form of waste control, fume reduction and machinery for the efficient production of certain products
- Vaccinations - While the point of vaccinations is to immunize oneself against infection, by doing so a person inadvertently reduces the possible number of carriers of the infection, thus reducing the risk of the sickness to others
- Education - By going through the education system you can increase your future standard of living, but an educated workforce strongly benefits a country's economy also
- Technology Spillover - This is when a firm’s innovation or design not only benefits the firm, but benefits society as a whole. This occurs in the form of waste control, fume reduction and machinery for the efficient production of certain products
Both Occurring Together
Like most things in life, however, externalities are not always in black and white. Many situations arise in the market which lead to both positive and negative externalities:
Building:
Building:
- Negative situations such as traffic congestion and noise pollution often arise
- In the long run, new buildings in an area can lead to an improvement in other infrastructure in the area, as well as a possible rise in house prices
- Cheque printing companies and postal companies can suffer from transactions completed online
- Companies wishing to use such facilities often need to set up equipment to do so, which has a positive impact on those selling that equipment
Internalisation
A huge part of a Government's job is to reduce negative externalities and promote positive externalities, in order to attempt to keep the market from failing. This use of incentives by Governments to correct externalities is called internalization.
Correcting negative externalities must be done through the use of duties and taxes, or strict regulations. By using duties to increase cigarette prices the Government encourages people not to smoke, and by placing carbon and pollution taxes on cars and factories they force companies to try to find cleaner methods of production. Taxes placed in order to internalize externalities are known as Pigovian taxes.
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Clearly Governments do not go out of their way to eliminate positive externalities. Instead they subsidize companies who beneficially effect the country. An example of such subsidies is a 'technology policy', a Government intervention in the economy that attempts to promote technology-enhancing industries. Patents are the results of such policies, and entitle the inventor of a new piece of technology to the rewards it produces, and guarantees the idea is his or hers alone for a period of time.
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Occasionally it is possible to reduce the effects of externalities privately (i.e. without the help of any Government) using:
- Moral codes and social sanctions
- Charitable organizations
- Integrating different types of businesses
- Contracting between parties
Graphically:
A product's demand and/or supply curves can be effected by externalities involved in their production or consumption.
Social Value curves are the result of a change in demand due to the externality, and Social Cost curves are the change in the supply.
Negative Externalities:
Either Social Cost is above Private Cost, or Social Value is below Private Value
Positive Externalities:
Either Social Cost is below Private Cost, or Social Value is above Private Value
The point of intersection of the adjusted curves is known as the Optimum, and is preferable to the previous Equilibrium price and quantity, as it accounts for externalities.
Social Value curves are the result of a change in demand due to the externality, and Social Cost curves are the change in the supply.
Negative Externalities:
Either Social Cost is above Private Cost, or Social Value is below Private Value
Positive Externalities:
Either Social Cost is below Private Cost, or Social Value is above Private Value
The point of intersection of the adjusted curves is known as the Optimum, and is preferable to the previous Equilibrium price and quantity, as it accounts for externalities.