Externality Definition Essay

Published: 2020-04-22 15:06:56
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1. An externality is defined as a benefit or cost that is imposed on a third party, such as society, other than the producer or consumer of a good or service, or, more simply, an economic side effect. The more of a product that is consumed or produced, the more of an externality that results. When discussing externalities in general terms, positive externalities refer to the benefits and negative externalities refer to the costs associated with the production or consumption of a good or service.

Public goods are one of the more common examples of positive externalities. Public goods are goods which are difficult to exclude people from benefiting from or from getting a free ride. Public goods, such as national defence, clean water, clean air, law enforcement, etc., are generally good for most, if not all of society.

Negative externalities exist in many situations. One of the most common examples is that of pollution. In these situations, the producer and consumer finance the goods produced but society must bear the cost of pollution that is introduced into the environment as a by-product and is thus a negative externality.

Using the above mentioned example of negative externality, pollution, a steel producing firm might pump pollutants into the air. While the firm has to pay for electricity, materials, etc., the individuals living around the factory will pay for the pollution since it will cause them to have higher medical expenses, poorer quality of life, reduced aesthetic appeal of the air, etc. Thus the production of steel by the firm has a negative cost to the people surrounding the factory-a cost that the steel firm doesnt have to pay.

2. Negative externalities are a property rights problem. Who owns the air that the steel mill pollutes? Ronald Coase put forth the solution which is known as the Coase Theorem: Under perfect competition, once government has assigned clearly defined property rights in contested resources and as long as transactions costs are negligible, private parties that generate or are affected by externalities will negotiate voluntary agreements that lead to the socially optimal resource allocation and output mix regardless of how the property rights are assigned (Ronald H. Coase, The Problem of Social Cost, The Journal of Law and Economics, October 1960).

In other words, if there are negligible transactions costs, as long as someone owns the rights to the air around the steel mill, the efficient outcome will prevail. For example, if the steel mill owns the rights, then the individuals that live around the mill will be willing to pay the steel mill not to produceup to the cost that they are incurring from health care, reduced aesthetic appeal of the air, etc. This amount that they are willing to pay becomes an opportunity cost for the steel mill if they produce. Thus they will cut production to the optimal level. On the other hand, if the people own the air, then the steel mill would have to pay them that same amount for the right to produce. Thus the negative externality is directly added to the steel mills marginal cost.

3. Based on experience, 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. This adds to the producers marginal cost and will cause them to reduce output.

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