1. What Is an Externality?

1.1 Externality
Externality or external cost is an indirect cost or benefit to an uninvolved third party that arises
as an effect of another party's (or parties') activity. Externalities can be considered as unpriced
components that are involved in either consumer or producer market transactions
The concept of externality was first developed by Alfred Marshall in the 1890s and achieved
broader attention in the works of economist Arthur Pigou in the 1920s. The prototypical example
of a negative externality is environmental pollution. Pigou argued that a tax, equal to the
marginal damage or marginal external cost, (later called a "Pigouvian tax") on negative
externalities could be used to reduce their incidence to an efficient level.[3] Subsequent thinkers
have debated whether it is preferable to tax or to regulate negative externalities,[4] the optimally
efficient level of the Pigouvian taxation,[5] and what factors cause or exacerbate negative
externalities, such as providing investors in corporations with limited liability for harms
committed by the corporation.[6][7][8]
Externalities often occur when the production/consumption of a product or service's private price
equilibrium cannot reflect the true costs/benefits of that product or service for society as a whole.
This causes the externality competitive equilibrium to not adhere to the condition of Pareto
optimality. Thus, since resources can be better allocated, externalities are an example of market
failure. Externalities can be either positive or negative
1.1.1 Types of Externalities
Externalities can be broken into two different categories. First, externalities can be measured as
good or bad as the side effects may enhance or be detrimental to an external party. These are
referred to as positive or negative externalities. Second, externalities can be defined by how they
are created. Most often, these are defined as a production or consumption externality.
1.1.1.1 Negative Externalities
Most externalities are negative. Pollution is a well-known negative externality. A corporation
may decide to cut costs and increase profits by implementing new operations that are more
harmful to the environment. The corporation realizes costs in the form of expanding operations
but also generates returns that are higher than the costs.
However, the externality also increases the aggregate cost to the economy and society making it
a negative externality. Externalities are negative when the social costs outweigh the private costs.
1.1.1.2 Positive Externalities
Some externalities are positive. Positive externalities occur when there is a positive gain on both
the private level and social level. Research and development (R&D) conducted by a company
can be a positive externality. R&D increases the private profits of a company but also has the
added benefit of increasing the general level of knowledge within a society.
Similarly, the emphasis on education is also a positive externality. Investment in education leads
to a smarter and more intelligent workforce. Companies benefit from hiring employees who are
educated because they are knowledgeable. This benefits employers because a better-educated
workforce requires less investment in employee training and development costs.
Governments and institutions often take actions to internalize externalities, thus market-priced
transactions can incorporate all the benefits and costs associated with transactions between
economic agents.[12][13] The most common way this is done is by imposing taxes on the
producers of this externality. This is usually done similar to a quote where there is no tax
imposed and then once the externality reaches a certain point there is a very high tax imposed.
However, since regulators do not always have all the information on the externality it can be
difficult to impose the right tax. Once the externality is internalized through imposing a tax the
competitive equilibrium is now Pareto optimal.
History of the concept
The term "externality" was first coined by the British economist Alfred Marshall in his seminal
work, "Principles of Economics," published in 1890. Marshall introduced the concept to
elucidate the effects of production and consumption activities that extend beyond the immediate
parties involved in a transaction. Marshall's formulation of externalities laid the groundwork for
subsequent scholarly inquiry into the broader societal impacts of economic actions. While
Marshall provided the initial conceptual framework for externalities, it was Arthur Pigou, a
British economist, who further developed the concept in his influential work, "The Economics of
Welfare," published in 1920. Pigou expanded upon Marshall's ideas and introduced the concept
of "Pigovian taxes" or corrective taxes aimed at internalizing externalities by aligning private
costs with social costs. His work emphasized the role of government intervention in addressing
market failures resulting from externalities.[2]
Additionally, the American economist Frank Knight contributed to the understanding of
externalities through his writings on social costs and benefits in the 1920s and 1930s. Knight's
work highlighted the inherent challenges in quantifying and mitigating externalities within
market systems, underscoring the complexities involved in achieving optimal resource
allocation.[14] Throughout the 20th century, the concept of externalities continued to evolve with
advancements in economic theory and empirical research. Scholars such as Ronald Coase and
Harold Hotelling made significant contributions to the understanding of externalities and their
implications for market efficiency and welfare.
The recognition of externalities as a pervasive phenomenon with wide-ranging implications has
led to its incorporation into various fields beyond economics, including environmental science,
public health, and urban planning. Contemporary debates surrounding issues such as climate
change, pollution, and resource depletion underscore the enduring relevance of the concept of
externalities in addressing pressing societal challenges.
Almost all externalities are considered to be technical externalities. Technical externalities have
an impact on the consumption and production opportunities of unrelated third parties, but the
price of consumption does not include the externalities. This exclusion creates a gap between the
gain or loss of private individuals and the aggregate gain or loss of society as a whole.
The action of an individual or organization often results in positive private gains but detracts
from the overall economy. Many economists consider technical externalities to be market
deficiencies, and this is the reason people advocate for government intervention to curb negative
externalities through taxation and regulation.
Externalities were once the responsibility of local governments and those affected by them. So,
for instance, municipalities were responsible for paying for the effects of pollution from a factory
in the area while the residents were responsible for their healthcare costs as a result of the
pollution.
1.2 What Is a Market?
A market is a place where parties can gather to facilitate the exchange of goods and services. The
parties involved are usually buyers and sellers. The market may be physical, like a retail outlet,
where people meet face-to-face, or virtual, like an online market, where there is no physical
presence or contact between buyers and sellers.
12.1 How Markets Work
A market is any place where two or more parties can meet to engage in an economic transaction
—even those that don't involve legal tender. A market transaction may include goods, services,
information, currency, or any combination that passes from one party to another. In short,
markets are arenas in which buyers and sellers can gather and interact.
Two parties are generally needed to make a trade. However, a third party is required to introduce
competition and balance the market. As such, a market in a state of perfect competition, among
other things, is characterized by a high number of active buyers and sellers.
1.2.2 Types of Markets
Markets vary widely for several reasons, including the kinds of products sold, location, duration,
and size. The constituency of the customer base, size, legality, and other factors are equally
influential. Aside from the two most common markets—physical and virtual—there are other
kinds of markets where parties can gather to execute their transactions.
Underground Market
An underground or black market refers to an illegal market where transactions occur without the
knowledge of the government or other regulatory agencies. Many illegal markets exist to
circumvent existing tax laws. This is why many involve cash-only transactions or non-traceable
forms of currency, making them harder to track.
Many illegal markets exist in economically developing countries with planned or command
economies where the government controls the production and distribution of goods and services.
When there is a shortage of specific goods and services in the economy, members of the illegal
market step in and fill the void.
Illegal markets can also exist in developed economies. These shadow markets, as they're also
known, become prevalent when prices control the sale of specific products or services, especially
when demand is high. Ticket scalping is one example of an illegal or shadow market. When
demand for concert or theater tickets is high, scalpers will step in, buy a bunch, and sell them at
inflated prices on the underground market.
Auction Market
An auction market brings many people together for the sale and purchase of specific lots of
goods. The buyers or bidders try to top each other for the purchase price. The items for sale go to
the highest bidder.
The most common auction markets involve livestock, foreclosed homes, and art and antiques.
Many operate online now. For example, the U.S. Treasury sells its bonds, notes, and bills via
regular auctions.1
Financial Market
The blanket term "financial market" refers to any place where securities, currencies, and bonds
are traded between two parties. These markets are the basis of capitalist societies, providing
capital formation and liquidity for businesses. They can be physical or virtual.
The financial market includes the stock exchanges such as the New York Stock
Exchange (NYSE), Nasdaq, the London Stock Exchange (LSE), and the TMX Group. Other
financial markets include the bond and foreign exchange markets, where people trade currencies.
Regulating Markets
Other than underground markets, most markets are subject to rules and regulations set by
governing body that determines the market’s nature. This may be the case when the regulation is
as wide-reaching and as widely recognized as an international trade agreement or as local and
temporary as a pop-up street market where vendors maintain order and rules among themselves.
1.3 What is resource allocation?
Allocation of resources, apportionment of productive assets among different uses. Resource
allocation arises as an issue because the resources of a society are in limited supply, whereas
human wants are usually unlimited, and because any given resource can have many alternative
uses.
In free-enterprise systems, the price system is the primary mechanism through which resources
are distributed among the uses most desired by consumers. In planned economies and in the
public sectors of mixed economies, the decisions regarding resource distribution are political.
Within the limits of existing technology, the aim of any economizing agency is to allocate
resources in a manner that obtains the maximum possible output from a given combination of
resources.
Resource allocation is the process of assigning and managing assets in a manner that supports an
organization's strategic planning goals.
Resource allocation includes managing tangible assets such as hardware to make the best use of
softer assets such as human capital. Resource allocation involves balancing competing needs and
priorities, and determining the best course of action to maximize the use of limited resources and
get the best return on investment.
In practicing resource allocation, organizations must first establish their desired goal, such as
increased revenue, improved productivity or better brand recognition. They then must assess
what resources will be needed to reach that goal.
While resource allocation often refers to activities related to project management, the term is also
used in other contexts, including the following:
 economics, where it is a component of public finance; and
 Computer storage, where it describes how operating systems manage data storage
resources.
How Can You Identify an Externality?
Companies must be mindful of their entire production process when assessing production
externalities. This includes not only implications of the final product but residual impacts of
byproducts, disposal of items not used, and how antiquated equipment is handled. This also
includes projecting outcomes of items yet to occur, such as waste yet to be properly disposed of.
Consumers can identify consumption externalities by being mindful of the inputs and outputs
that go beyond what they are attempting to achieve. Consider an example of an individual
consuming alcohol. A consumer must be mindful that excessive drinking may lead to noise
pollution, an unsafe environment, or adverse health effects.
Impacts of externalities
When the consumption and/or production of one or more economic agents affect the utility
and/or production of one or more other economic agents and there is no compensation involved,
then this occurrence is called Externalities (Arrow, 1971). It can be both Positive and Negative.
In simple terms, increase in cost resulting from an Externality is Negative Externality, while
increase in benefit is Positive Externality.
There are numerous examples of Negative Externalities as it is more common in general. For
instance, we can take a look at the Textile factories in Dhaka, Bangladesh. Many of the factories
in that region were built just by the rivers so that they can discharge industrial wastes. However,
many people in the neighborhood depend on rivers for fishing and agriculture. If we consider a
textile factory in a standard market, assuming that a factory is producing a specific type of fabric
in Q* amount at P* price, when supply is S and demand is D (Figure).
Every unit of fabric generates some industrial wastes, thereby polluting the river. This pollution
generates some costs (C) for fishery and agriculture. The cost increases with the increase of
production. If we take that into account, we can get a new supply (MSC), which equals Private
cost from the textile factory and cost for fishery and agriculture. Mathematically,

MSC = MPC + C

So, there is a new socially efficient level, P’ and Q’ (Figure). We can see that the private and
social efficiency levels diverge as the additional societal cost is not included in the production
decisions of the textile factory.

This is part of the real production cost and it is not being recognized by the factory. So, if they
are allowed to continue the production process and continue polluting, there will be too many
products at some point. The product will not be allocated according to its real economic price.
This is how negative externality leads to inefficient allocation of resources.

2.
2.1 Negative
A negative externality (also called "external cost" or "external diseconomy") is an economic
activity that imposes a negative effect on an unrelated third party, not captured by the market
price. It can arise either during the production or the consumption of a good or service. Many
negative externalities are related to the environmental consequences of production and use.
Types of A negative externality
2.1.1. Negative production externalities
Examples include:
 Air pollution from burning fossil fuels. This activity causes damages to crops, materials
and (historic) buildings and public health.[21][22]
 Anthropogenic climate change as a consequence of greenhouse gas emissions from the
burning of fossil fuels and the rearing of livestock. The Stern Review on the Economics of
Climate Change says "Climate change presents a unique challenge for economics: it is
the greatest example of market failure we have ever seen."[23]
 Water pollution from industrial effluents can harm plants, animals, and humans
 Spam emails during the sending of unsolicited messages by email.[24]
 Noise pollution during the production process, which may be mentally and
psychologically disruptive.
 Systemic risk: the risks to the overall economy arising from the risks that the banking
system takes. A condition of moral hazard can occur in the absence of well-
designed banking regulation,[25] or in the presence of badly designed regulation.[26]
 Negative effects of Industrial farm animal production, including "the increase in the pool
of antibiotic-resistant bacteria because of the over use of antibiotics; air quality problems;
the contamination of rivers, streams, and coastal waters with concentrated animal waste;
animal welfare problems, mainly as a result of the extremely close quarters in which the
animals are housed."[27][28]
 The depletion of the stock of fish in the ocean due to overfishing. This is an example of
a common property resource, which is vulnerable to the tragedy of the commons in the
absence of appropriate environmental governance.
2.2.2. Negative consumption externalities
 Noise pollution: Sleep deprivation due to a neighbor listening to loud music late at night.
 Antibiotic resistance, caused by increased usage of antibiotics: Individuals do not
consider this efficacy cost when making usage decisions. Government policies proposed
to preserve future antibiotic effectiveness include educational campaigns,
regulation, Pigouvian taxes, and patents.
 Passive smoking: Shared costs of declining health and vitality caused by smoking or
alcohol abuse. Here, the "cost" is that of providing minimum social welfare. Economists
more frequently attribute this problem to the category of moral hazards, the prospect that
parties insulated from risk may behave differently from the way they would if they were
fully exposed to the risk. For example, individuals with insurance against automobile
theft may be less vigilant about locking their cars, because the negative consequences of
automobile theft are (partially) borne by the insurance company.
 Traffic congestion: When more people use public roads, road users experience congestion
costs such as more waiting in traffic and longer trip times. Increased road users also
increase the likelihood of road accidents.[29]
  Price increases: Consumption by one party causes prices to rise and therefore makes
other consumers worse off, perhaps by preventing, reducing or delaying their
consumption. These effects are sometimes called "pecuniary externalities" and are
distinguished from "real externalities" or "technological externalities". Pecuniary
externalities appear to be externalities, but occur within the market mechanism and are
not considered to be a source of market failure or inefficiency, although they may still
result in substantial harm to others.[30]
 Weak public infrastructure, air pollution, climate change, work misallocation, resource
requirements and land/space requirements as in the externalities of automobiles.[31]
2.2. Positive
A positive externality (also called "external benefit" or "external economy" or "beneficial
externality") is the positive effect an activity imposes on an unrelated third party. [32] Similar to a
negative externality, it can arise either on the production side, or on the consumption side.[18]
A positive production externality occurs when a firm's production increases the well-being of
others but the firm is uncompensated by those others, while a positive consumption externality
occurs when an individual's consumption benefits other but the individual is uncompensated by
those others.[33]
2.2.1 Positive production externalities
Examples of positive production externalities
 A beekeeper who keeps the bees for their honey. A side effect or externality associated
with such activity is the pollination of surrounding crops by the bees. The value generated
by the pollination may be more important than the value of the harvested honey.
 The corporate development of some free software (studied notably by Jean
Tirole and Steven Weber[34])
 Research and development, since much of the economic benefits of research are not
captured by the originating firm.[35]
 An industrial company providing first aid classes for employees to increase on the job
safety. This may also save lives outside the factory.
 Restored historic buildings may encourage more people to visit the area and patronize
nearby businesses.[36]
 A foreign firm that demonstrates up-to-date technologies to local firms and improves
their productivity.[37]
 Public transport can increase economic welfare by providing transit services to other
economic activities, however the benefits of those other economic activities are not felt
by the operator, it can also decrease the negative externalities of increasing road
patronage in the absence of a congestion charge.[38]
2.2.1 Positive consumption externalities
Examples include:
 An individual who maintains an attractive house may confer benefits to neighbors in the
form of increased market values for their properties. This is an example of a pecuniary
externality, because the positive spillover is accounted for in market prices. In this case,
house prices in the neighborhood will increase to match the increased real estate value
from maintaining their aesthetic. (such as by mowing the lawn, keeping the trash orderly,
and getting the house painted) [39]
 Anything that reduces the rate of transmission of an infectious disease carries positive
externalities. This includes vaccines, quarantine, tests and other diagnostic procedures.
For airborne infections, it also includes masking. For waterborne diseases, it includes
improved sewers and sanitation.[40]
 Increased education of individuals, as this can lead to broader society benefits in the form
of greater economic productivity, a lower unemployment rate, greater household mobility
and higher rates of political participation.[41]
 An individual buying a product that is interconnected in a network (e.g., a smartphone).
This will increase the usefulness of such phones to other people who have a video
cellphone. When each new user of a product increases the value of the same product
owned by others, the phenomenon is called a network externality or a network effect.
Network externalities often have "tipping points" where, suddenly, the product reaches
general acceptance and near-universal usage.
 In an area that does not have a public fire department, homeowners who
purchase private fire protection services provide a positive externality to neighboring
properties, which are less at risk of the protected neighbor's fire spreading to their
(unprotected) house.
Collective solutions or public policies are implemented to regulate activities with positive or
negative externalities.
2.2. Positional
The sociological basis of Positional externalities is rooted in the theories of conspicuous
consumption and positional goods.[42]
Conspicuous consumption (originally articulated by Veblen, 1899) refers to the consumption of
goods or services primarily for the purpose of displaying social status or wealth. In simpler
terms, individuals engage in conspicuous consumption to signal their economic standing or to
gain social recognition.[43] Positional goods (introduced by Hirsch, 1977) are such goods, whose
value is heavily contingent upon how they compare to similar goods owned by others. Their
desirability is or derived utility is intrinsically tied to their relative scarcity or exclusivity within
a particular social context.[44]
The economic concept of Positional externalities originates from Duesenberry's Relative Income
Hypothesis. This hypothesis challenges the conventional microeconomic model, as outlined by
the Common Pool Resource (CPR) mechanism, which typically assumes that an individual's
utility derived from consuming a particular good or service remains unaffected by other's
consumption choices. Instead, Duesenberry posits that individuals gauge the utility of their
consumption based on a comparison with other consumption bundles, thus introducing the notion
of relative income into economic analysis. Consequently, the consumption of positional goods
becomes highly sought after, as it directly impacts one's perceived status relative to others in
their social circle.[45]
Example: consider a scenario where individuals within a social group vie for the latest luxury
cars. As one member acquires a top-of-the-line vehicle, others may feel compelled to upgrade
their own cars to preserve their status within the group. This cycle of competitive consumption
can result in inefficient allocation of resources and exacerbate income inequality within society.
The consumption of positional goods engenders negative externalities, wherein the acquisition of
such goods by one individual diminishes the utility or value of similar goods held by others
within the same reference group. This positional externality, can lead to a cascade of
overconsumption, as individuals strive to maintain or improve their relative position through
excessive spending.
Positional externalities are related, but not similar to pecuniary externalities.
2.4 Pecuniary
Pecuniary externalities are those which affect a third party's profit but not their ability to produce
or consume. These externalities "occur when new purchases alter the relevant context within
which an existing positional good is evaluated."[46] Robert H. Frank gives the following example:
If some job candidates begin wearing expensive custom-tailored suits, a side effect of their action
is that other candidates become less likely to make favorable impressions on interviewers. From
any individual job seeker's point of view, the best response might be to match the higher
expenditures of others, lest her chances of landing the job fall. But this outcome may be
inefficient since when all spend more, each candidate's probability of success remains
unchanged. All may agree that some form of collective restraint on expenditure would be
useful."[46]
Frank notes that treating positional externalities like other externalities might lead to "intrusive
economic and social regulation."[46] He argues, however, that less intrusive and more efficient
means of "limiting the costs of expenditure cascades"—i.e., the hypothesized increase in
spending of middle-income families beyond their means "because of indirect effects associated
with increased spending by top earners"—exist; one such method is the personal income tax.[46]
2.5 Inframarginal
The concept of inframarginal externalities was introduced by James Buchanan and Craig
Stubblebine in 1962.[47] Inframarginal externalities differ from other externalities in that there is
no benefit or loss to the marginal consumer. At the relevant margin to the market, the externality
does not affect the consumer and does not cause market inefficiency. The externality only affects
at the inframarginal range outside where the market clears. These types of externalities do not
cause inefficient allocation of resources and do not require policy action.
2.5 Technological
Technological externalities directly affect a firm's production and therefore, indirectly influence
an individual's consumption; and the overall impact of society; for example Open-source
software or free software development by corporations.
3. Externality Solutions
There are solutions that exist to overcome the negative effects of externalities. These can include
those from both the public and private sectors.
Taxes
Taxes are one solution to overcoming externalities. To help reduce the negative effects of certain
externalities such as pollution, governments can impose a tax on the goods causing the
externalities. The tax called a Pigovian tax—named after economist Arthur C. Pigou—is
considered to be equal to the value of the negative externality.
This tax is meant to discourage activities that impose a net cost to an unrelated third party. That
means that the imposition of this type of tax will reduce the market outcome of the externality to
an amount that is considered efficient.
Subsidies
Subsidies can also overcome negative externalities by encouraging the consumption of a positive
externality. One example would be to subsidize orchards that plant fruit trees to provide positive
externalities to beekeepers.
This nudge has the potential to influence behavioral economics, as additional incentives one way
or another way dictate the choices that are made. The subsidy is often placed on an opposing
item to detract from a specific activity as well. For example, government incentives to upgrade to
more energy-efficient renovations subtly discourage consumers against options with more
externalities.
Other Government Regulation
Governments can also implement regulations to offset the effects of externalities. Regulation is
considered the most common solution. The public often turns to governments to pass and enact
legislation and regulation to curb the negative effects of externalities. Several examples include
environmental regulations or health-related legislation.
The primary issue with government regulation of externalities is the need for consistent and
reliable information to track the externality is being managed or overcome. Consider regulation
against pollution. The government put forth resources to ensure that the legislation put in place is
actually being followed, including holding bad actors accountable for not properly addressing
their externality.
Supply and demand diagram [edit]
The usual economic analysis of externalities can be illustrated using a standard supply and
demand diagram if the externality can be valued in terms of money. An extra supply or demand
curve is added, as in the diagrams below. One of the curves is the private cost that consumers
pay as individuals for additional quantities of the good, which in competitive markets, is the
marginal private cost. The other curve is the true cost that society as a whole pays for production
and consumption of increased production the good, or the marginal social cost. Similarly, there
might be two curves for the demand or benefit of the good. The social demand curve would
reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to
consumers as individuals and is reflected as effective demand in the market.
What curve is added depends on the type of externality that is described, but not whether it is
positive or negative. Whenever an externality arises on the production side, there will be two
supply curves (private and social cost). However, if the externality arises on the consumption
side, there will be two demand curves instead (private and social benefit). This distinction is
essential when it comes to resolving inefficiencies that are caused by externalities.
External costs[edit]
 Demand curve with external costs; if
social costs are not accounted for price is too low to cover all costs and hence quantity produced
is unnecessarily high (because the producers of the good and their customers are essentially
underpaying the total, real factors of production.)
The graph shows the effects of a negative externality. For example, the steel industry is assumed
to be selling in a competitive market – before pollution-control laws were imposed and enforced
(e.g. under laissez-faire). The marginal private cost is less than the marginal social or public cost
by the amount of the external cost, i.e., the cost of air pollution and water pollution. This is
represented by the vertical distance between the two supply curves. It is assumed that there are
no external benefits, so that social benefit equals individual benefit.
If the consumers only take into account their own private cost, they will end up at price Pp and
quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea
that the marginal social benefit should equal the marginal social cost, that is that production
should be increased only as long as the marginal social benefit exceeds the marginal social cost.
The result is that a free market is inefficient since at the quantity Qp, the social benefit is less than
the social cost, so society as a whole would be better off if the goods between Qp and Qs had not
been produced. The problem is that people are buying and consuming too much steel.
This discussion implies that negative externalities (such as pollution) are more than merely an
ethical problem. The problem is one of the disjunctures between marginal private and social
costs that are not solved by the free market. It is a problem of societal communication and
coordination to balance costs and benefits. This also implies that pollution is not something
solved by competitive markets. Some collective solution is needed, such as a court system to
allow parties affected by the pollution to be compensated, government intervention banning or
discouraging pollution, or economic incentives such as green taxes.
External benefits[edit]
 Supply curve with external benefits;
when the market does not account for the additional social benefits of a good both the price for
the good and the quantity produced are lower than the market could bear.
The graph shows the effects of a positive or beneficial externality. For example, the industry
supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal
private benefit of getting the vaccination is less than the marginal social or public benefit by the
amount of the external benefit (for example, society as a whole is increasingly protected from
smallpox by each vaccination, including those who refuse to participate). This marginal external
benefit of getting a smallpox shot is represented by the vertical distance between the two demand
curves. Assume there are no external costs, so that social cost equals individual cost.
If consumers only take into account their own private benefits from getting vaccinations, the
market will end up at price Pp and quantity Qp as before, instead of the more efficient
price Ps and quantity Qs. This latter again reflect the idea that the marginal social benefit should
equal the marginal social cost, i.e., that production should be increased as long as the marginal
social benefit exceeds the marginal social cost. The result in an unfettered
market is inefficient since at the quantity Qp, the social benefit is greater than the societal cost, so
society as a whole would be better off if more goods had been produced. The problem is that
people are buying too few vaccinations.
The issue of external benefits is related to that of public goods, which are goods where it is
difficult if not impossible to exclude people from benefits. The production of a public good has
beneficial externalities for all, or almost all, of the public. As with external costs, there is a
problem here of societal communication and coordination to balance benefits and costs. This also
implies that vaccination is not something solved by competitive markets. The government may
have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If
the government does this, the good is called a merit good. Examples include policies to
accelerate the introduction of electric vehicles[48] or promote cycling,[49] both of which
benefit public health.
Causes[edit]
Externalities often arise from poorly defined property rights. While property rights to some
things, such as objects, land, and money can be easily defined and protected, air, water, and wild
animals often flow freely across personal and political borders, making it much more difficult to
assign ownership. This incentivizes agents to consume them without paying the full cost, leading
to negative externalities. Positive externalities similarly accrue from poorly defined property
rights. For example, a person who gets a flu vaccination cannot own part of the herd
immunity this confers on society, so they may choose not to be vaccinated.
Another common cause of externalities is the presence of transaction costs.[50] Transaction costs
are the cost of making an economic trade. These costs prevent economic agents from making
exchanges they should be making. The costs of the transaction outweigh the benefit to the agent.
When not all mutually beneficial exchanges occur in a market, that market is inefficient. Without
transaction costs, agents could freely negotiate and internalize all externalities.
Possible solutions [edit]
Solutions in non-market economies [edit]
 In planned economies, production is typically limited only to necessity, which would
eliminate externalities created by overproduction.
 The central planner can decide to create and allocate jobs in industries that work to
mitigate externalities, rather than waiting for the market to create a demand for these
jobs.

Solutions in market economies [edit]

There are several general types of solutions to the problem of externalities, including both
public- and private-sector resolutions:
 Corporations or partnerships will allow confidential sharing of information among
members, reducing the positive externalities that would occur if the information were
shared in an economy consisting only of individuals.
 Pigovian taxes or subsidies intended to redress economic injustices or imbalances.
 Regulation to limit activity that might cause negative externalities
 Government provision of services with positive externalities
 Lawsuits to compensate affected parties for negative externalities
 Voting to cause participants to internalize externalities subject to the conditions of
the efficient voter rule.[51]
 Mediation or negotiation between those affected by externalities and those causing them
A Pigovian tax (also called Pigouvian tax, after economist Arthur C. Pigou) is a tax imposed that
is equal in value to the negative externality. In order to fully correct the negative externality, the
per unit tax should equal the marginal external cost. [52] The result is that the market outcome
would be reduced to the efficient amount. A side effect is that revenue is raised for the
government, reducing the amount of distortionary taxes that the government must impose
elsewhere. Governments justify the use of Pigovian taxes saying that these taxes help the market
reach an efficient outcome because this tax bridges the gap between marginal social costs and
marginal private costs.[53]
Some arguments against Pigovian taxes say that the tax does not account for all the transfers and
regulations involved with an externality. In other words, the tax only considers the amount of
externality produced.[54] Another argument against the tax is that it does not take private property
into consideration. Under the Pigovian system, one firm, for example, can be taxed more than
another firm, even though the other firm is actually producing greater amounts of the negative
externality.[55]
Further arguments against Pigou disagree with his assumption every externality has someone at
fault or responsible for the damages.[56] Coase argues that externalities are reciprocal in nature.
Both parties must be present for an externality to exist. He uses the example of two neighbors.
One neighbor possesses a fireplace, and often lights fires in his house without issue. Then one
day, the other neighbor builds a wall that prevents the smoke from escaping and sends it back
into the fire-building neighbor’s home. This illustrates the reciprocal nature of externalities.
Without the wall, the smoke would not be a problem, but without the fire, the smoke would not
exist to cause problems in the first place. Coase also takes issue with Pigou’s assumption of a
“benevolent despot” government. Pigou assumes the government’s role is to see the external
costs or benefits of a transaction and assign an appropriate tax or subsidy. Coase argues that the
government faces costs and benefits just like any other economic agent, so other factors play into
its decision-making.
However, the most common type of solution is a tacit agreement through the political process.
Governments are elected to represent citizens and to strike political compromises between
various interests. Normally governments pass laws and regulations to address pollution and other
types of environmental harm. These laws and regulations can take the form of "command and
control" regulation (such as enforcing standards and limiting process variables),
or environmental pricing reform (such as ecotaxes or other Pigovian taxes, tradable pollution
permits or the creation of markets for ecological services). The second type of resolution is a
purely private agreement between the parties involved.
Government intervention might not always be needed. Traditional ways of life may have evolved
as ways to deal with external costs and benefits. Alternatively, democratically run communities
can agree to deal with these costs and benefits in an amicable way. Externalities can sometimes
be resolved by agreement between the parties involved. This resolution may even come about
because of the threat of government action.
The use of taxes and subsidies in solving the problem of externalities Correction tax, respectively
subsidy, means essentially any mechanism that increases, respectively decreases, the costs (and
thus price) associated with the activities of an individual or company.[57]
The private-sector may sometimes be able to drive society to the socially optimal
resolution. Ronald Coase argued that an efficient outcome can sometimes be reached without
government intervention. Some take this argument further, and make the political argument that
government should restrict its role to facilitating bargaining among the affected groups or
individuals and to enforcing any contracts that result.
This result, often known as the Coase theorem, requires that
 Property rights be well-defined
 People act rationally
 Transaction costs be minimal (costless bargaining)
 Complete information
If all of these conditions apply, the private parties can bargain to solve the problem of
externalities. The second part of the Coase theorem asserts that, when these conditions hold,
whoever holds the property rights, a Pareto efficient outcome will be reached through bargaining.
This theorem would not apply to the steel industry case discussed above. For example, with a
steel factory that trespasses on the lungs of a large number of individuals with pollution, it is
difficult if not impossible for any one person to negotiate with the producer, and there are large
transaction costs. Hence the most common approach may be to regulate the firm (by imposing
limits on the amount of pollution considered "acceptable") while paying for the regulation and
enforcement with taxes. The case of the vaccinations would also not satisfy the requirements of
the Coase theorem. Since the potential external beneficiaries of vaccination are the people
themselves, the people would have to self-organize to pay each other to be vaccinated. But such
an organization that involves the entire populace would be indistinguishable from government
action.
In some cases, the Coase theorem is relevant. For example, if a logger is planning to clear-cut
a forest in a way that has a negative impact on a nearby resort, the resort-owner and the logger
could, in theory, get together to agree to a deal. For example, the resort-owner could pay the
logger not to clear-cut – or could buy the forest. The most problematic situation, from Coase's
perspective, occurs when the forest literally does not belong to anyone, or in any example in
which there are not well-defined and enforceable property rights; the question of "who" owns the
forest is not important, as any specific owner will have an interest in coming to an agreement
with the resort owner (if such an agreement is mutually beneficial).
However, the Coase theorem is difficult to implement because Coase does not offer a negotiation
method.[58] Moreover, Coasian solutions are unlikely to be reached due to the possibility of
running into the assignment problem, the holdout problem, the free-rider problem, or transaction
costs. Additionally, firms could potentially bribe each other since there is little to no government
interaction under the Coase theorem.[59] For example, if one oil firm has a high pollution rate and
its neighboring firm is bothered by the pollution, then the latter firm may move depending on
incentives. Thus, if the oil firm were to bribe the second firm, the first oil firm would suffer no
negative consequences because the government would not know about the bribing.
In a dynamic setup, Rosenkranz and Schmitz (2007) have shown that the impossibility to rule out
Coasean bargaining tomorrow may actually justify Pigouvian intervention today. [60] To see this,
note that unrestrained bargaining in the future may lead to an underinvestment problem (the so-
called hold-up problem). Specifically, when investments are relationship-specific and non-
contractible, then insufficient investments will be made when it is anticipated that parts of the
investments’ returns will go to the trading partner in future negotiations (see Hart and Moore,
1988).[61] Hence, Pigouvian taxation can be welfare-improving precisely because Coasean
bargaining will take place in the future. Antràs and Staiger (2012) make a related point in the
context of international trade.[62]
Kenneth Arrow suggests another private solution to the externality problem. [63] He believes
setting up a market for the externality is the answer. For example, suppose a firm produces
pollution that harms another firm. A competitive market for the right to pollute may allow for an
efficient outcome. Firms could bid the price they are willing to pay for the amount they want to
pollute, and then have the right to pollute that amount without penalty. This would allow firms to
pollute at the amount where the marginal cost of polluting equals the marginal benefit of another
unit of pollution, thus leading to efficiency.
Frank Knight also argued against government intervention as the solution to externalities. [64] He
proposed that externalities could be internalized with privatization of the relevant markets. He
uses the example of road congestion to make his point. Congestion could be solved through the
taxation of public roads. Knight shows that government intervention is unnecessary if roads were
privately owned instead. If roads were privately owned, their owners could set tolls that would
reduce traffic and thus congestion to an efficient level. This argument forms the basis of the
traffic equilibrium. This argument supposes that two points are connected by two different
highways. One highway is in poor condition, but is wide enough to fit all traffic that desires to
use it. The other is a much better road, but has limited capacity. Knight argues that, if a large
number of vehicles operate between the two destinations and have freedom to choose between
the routes, they will distribute themselves in proportions such that the cost per unit of
transportation will be the same for every truck on both highways. This is true because as more
trucks use the narrow road, congestion develops and as congestion increases it becomes equally
profitable to use the poorer highway. This solves the externality issue without requiring any
government tax or regulations.
Solutions to greenhouse gas emission externalities [edit]
The negative effect of carbon emissions and other greenhouse gases produced in production
exacerbate the numerous environmental and human impacts of anthropogenic climate change.
These negative effects are not reflected in the cost of producing, nor in the market price of the
final goods. There are many public and private solutions proposed to combat this externality
Emissions fee [edit]
An emissions fee, or carbon tax, is a tax levied on each unit of pollution produced in the
production of a good or service. The tax incentivized producers to either lower their production
levels or to undertake abatement activities that reduce emissions by switching to cleaner
technology or inputs.[65]
Cap-and-trade systems [edit]
The cap-and-trade system enables the efficient level of pollution (determined by the government)
to be achieved by setting a total quantity of emissions and issuing tradable permits to polluting
firms, allowing them to pollute a certain share of the permissible level. Permits will be traded
from firms that have low abatement costs to firms with higher abatement costs and therefore the
system is both cost-effective and cost-efficient. The cap and trade system has some practical
advantages over an emissions fee such as the fact that: 1. it reduces uncertainty about the
ultimate pollution level. 2. If firms are profit maximizing, they will utilize cost-minimizing
technology to attain the standard which is efficient for individual firms and provides incentives
to the research and development market to innovate. 3. The market price of pollution rights
would keep pace with the price level while the economy experiences inflation.
The emissions fee and cap and trade systems are both incentive-based approaches to solving a
negative externality problem.
Command-and-control regulations [edit]
Command-and-control regulations act as an alternative to the incentive-based approach. They
require a set quantity of pollution reduction and can take the form of either a technology standard
or a performance standard. A technology standard requires pollution producing firms to use
specified technology. While it may reduce the pollution, it is not cost-effective and stifles
innovation by incentivizing research and development for technology that would work better
than the mandated one. Performance standards set emissions goals for each polluting firm. The
free choice of the firm to determine how to reach the desired emissions level makes this option
slightly more efficient than the technology standard, however, it is not as cost-effective as the
cap-and-trade system since the burden of emissions reduction cannot be shifted to firms with
lower abatement.[66]
Scientific calculation of external costs [edit]
"Relative percentage price [∆] increases for broad categories [...] when externalities of
greenhouse gas emissions are included in the producer's price."[67]
A 2020 scientific analysis of external climate costs of foods indicates that external greenhouse
gas costs are typically highest for animal-based products – conventional and organic to about the
same extent within that ecosystem-subdomain – followed by conventional dairy products and
lowest for organic plant-based foods and concludes that contemporary monetary evaluations are
"inadequate" and that policy-making that lead to reductions of these costs to be possible,
appropriate and urgent.[68][69][67]
Criticism [edit]
Ecological economics criticizes the concept of externality because there is not enough system
thinking and integration of different sciences in the concept. Ecological economics is founded
upon the view that the neoclassical economics (NCE) assumption that environmental and
community costs and benefits are mutually cancelling "externalities" is not warranted. Joan
Martinez Alier,[70] for instance shows that the bulk of consumers are automatically excluded from
having an impact upon the prices of commodities, as these consumers are future generations who
have not been born yet. The assumptions behind future discounting, which assume that future
goods will be cheaper than present goods, has been criticized by Fred Pearce[71] and by the Stern
Report (although the Stern report itself does employ discounting and has been criticized for this
and other reasons by ecological economists such as Clive Spash).[72]
Concerning these externalities, some, like the eco-businessman Paul Hawken, argue an orthodox
economic line that the only reason why goods produced unsustainably are usually cheaper than
goods produced sustainably is due to a hidden subsidy, paid by the non-monetized human
environment, community or future generations. [73] These arguments are developed further by
Hawken, Amory and Hunter Lovins to promote their vision of an environmental capitalist utopia
in Natural Capitalism: Creating the Next Industrial Revolution.[74]
In contrast, ecological economists, like Joan Martinez-Alier, appeal to a different line of
reasoning.[75] Rather than assuming some (new) form of capitalism is the best way forward, an
older ecological economic critique questions the very idea of internalizing externalities as
providing some corrective to the current system. The work by Karl William Kapp[76] argues that
the concept of "externality" is a misnomer.[77] In fact the modern business enterprise operates on
the basis of shifting costs onto others as normal practice to make profits. [78] Charles
Eisenstein has argued that this method of privatising profits while socialising the costs through
externalities, passing the costs to the community, to the natural environment or to future
generations is inherently destructive.[79] Social ecological economist Clive Spash argues that
externality theory fallaciously assumes environmental and social problems are minor aberrations
in an otherwise perfectly functioning efficient economic system. [80] Internalizing the odd
externality does nothing to address the structural systemic problem and fails to recognize the all
pervasive nature of these supposed 'externalities'. This is precisely why heterodox economists
argue for a heterodox theory of social costs to effectively prevent the problem through the
precautionary principle.[81]