Externalities
Externalities refer to the unintended consequences of an economic activity that affect third parties who are not involved in the transaction. These effects can be positive or negative, but negative externalities often lead to societal issues when costs are imposed on unwilling participants. For instance, noise from a party in an apartment building may disturb neighbors, or pollution from a factory may degrade the quality of the environment, affecting local residents. In such cases, the initial parties may benefit from their activities, while others bear the burdens, leading to potential inequities.
Manufacturers, for example, may externalize costs by polluting without directly bearing the consequences, resulting in increased production beyond socially optimal levels. To address externalities, governments may implement regulations or taxes to encourage companies to internalize these costs, prompting them to adopt cleaner practices or reduce harmful outputs. The resolution of conflicts arising from externalities often involves determining who should absorb costs and how best to mitigate harm, with courts frequently stepping in to adjudicate these disputes. Ultimately, understanding externalities is crucial for fostering fair economic practices and protecting community welfare.
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Subject Terms
Externalities
DEFINITION: Effects that are imposed on third parties who were not voluntarily involved in the activity or transaction creating them
Parties who voluntarily engage in market transactions expect to benefit from them, but if a transaction imposes costs on unwilling third parties, the transaction might be unfair to those parties and might create a net loss for society.
When one resident of an apartment building has a party, his or her neighbors may be bothered by the noise. If an office building is built next to a resort hotel, shading the latter’s swimming pool, the hotel may lose business. If a pig farm is close to a housing development, the noise, smells, and flies that go along with the farming operation may reduce the property value of the houses. These are examples of externalities.
Consider a manufacturer of automobiles, who must pay for the land, equipment, materials, labor, utilities, advertising, and myriad other costs that are necessary for the production process. Pollution is also a cost that results from the manufacturing process. Suppose the manufacturer is able to avoid paying the cost of disposing of the pollutants by releasing them into the air or water near the plant, so that the costs are instead borne by the surrounding or downstream landowners. The manufacturer would be externalizing the cost—that is, making someone else pay for it.
A rational manufacturer will maximize profit by increasing the level of production so long as each unit can be sold for more than its cost. Suppose an automaker calculates that producing one additional car will add $20,000 to costs, but the car can be sold for $20,200. It makes sense to make that additional car. The manufacturer should, in fact, increase production until it is no longer possible to make a profit by making additional units. However, what if the external cost caused by pollution amounts to $500 of harm to the for each unit produced? If the manufacturer can externalize that cost by allowing others to absorb it, the calculation of the profit-maximizing number of units is not affected. The social cost (manufacturing cost plus harm caused by pollution) for the marginal units actually exceeds the value of the automobile, as measured by its purchase price. The manufacturer thus has incentive to produce more than the socially optimal amount of pollution and more than the optimal number of automobiles.
If forced to “internalize” the pollution cost—that is, to pay for it—the manufacturer would reduce the amount of pollution and the number of units produced to the socially optimal level. One way in which governments force manufacturers to internalize pollution costs is by compelling specific pollution controls. For example, governments may mandate cleaner production processes or the safe disposal of liquid effluents. Another approach governments take is to impose taxes on effluents equal to the amount of harm the pollution causes. If manufacturers can find ways to reduce the pollution at costs lower than the taxes, they will do so.
In many externality cases, it is not obvious who should absorb the costs. In the case of the pig farm, should the farmer have to compensate the homeowners or move the farming operation to another location? Should homeowners who knew they were moving in next to a pig farm have the right to complain about the negative environmental impacts of the farm? Courts are commonly asked to resolve such conflicts. They often decide the issue by requiring the party who can solve the problem at lowest cost to do so.
Bibliography
Friedman, David D. Law’s Order: What Economics Has to Do with Law and Why It Matters. Princeton, N.J.: Princeton University Press, 2001.
Van Noordwijk, Meine, Beria Leimona, Sacha Amaruzaman, Unai Pascual, Peter A. Minang, and Ravi Prabhu. "Five Levels of Internalizing Environmental Externalities: Decision-Making Based on Instrumental and Relational Values of Nature." Current Opinion in Environmental Sustainability, vol. 63, 2023. DOI: 10.1016/j.cosust.2023.101299. Accessed 17 July 2024.
Winston, Clifford. Government Failure Versus Market Failure: Microeconomic Policy Research and Government Performance. Washington, D.C.: Brookings Institution Press, 2006.