Externality
In economics, an 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. Air pollution from motor vehicles is one example. The cost of air pollution to society is not paid by either the producers or users of motorized transport to the rest of society. Water pollution from mills and factories is another example. All (water) consumers are made worse off by pollution but are not compensated by the market for this damage. A positive externality is when an individual's consumption in a market increases the well-being of others, but the individual does not charge the third party for the benefit. The third party is essentially getting a free product. An example of this might be the apartment above a bakery receiving some free heat in winter. The people who live in the apartment do not compensate the bakery for this benefit.[1]
The concept of externality was first developed by Alfred Marshall in the 1890s[2] and achieved broader attention in the works of economist Arthur Pigou in the 1920s.[3] 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 or consumption of a product or service's private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole.[9][10] 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.[11]
Externalities can be either positive or negative. 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[edit]
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.
Definitions[edit]
A negative externality is any difference between the private cost of an action or decision to an economic agent and the social cost. In simple terms, a negative externality is anything that causes an indirect cost to individuals. An example is the toxic gases that are released from industries or mines, these gases cause harm to individuals within the surrounding area and have to bear a cost (indirect cost) to get rid of that harm. Conversely, a positive externality is any difference between the private benefit of an action or decision to an economic agent and the social benefit. A positive externality is anything that causes an indirect benefit to individuals and for which the producer of that positive externality is not compensated. For example, planting trees makes individuals' property look nicer and it also cleans the surrounding areas.
In microeconomic theory, externalities are factored into competitive equilibrium analysis as the social effect, as opposed to the private market which only factors direct economic effects. The social effect of economic activity is the sum of the indirect (the externalities) and direct factors. The Pareto optimum, therefore, is at the levels in which the social marginal benefit equals the social marginal cost.
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.
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]