Externalities are side effects of economic activity that affect people who are not directly part of a transaction. They matter because market prices often include the private costs paid by buyers and sellers, but may leave out costs or benefits that spill over to others. A factory that sells cheap goods while polluting a river creates a cost for nearby residents, fishers, and taxpayers.
Understanding externalities helps students see why some markets may produce too much of harmful goods or too little of helpful goods.
Key Facts
- Externality = a cost or benefit that affects a third party outside the market transaction.
- Negative externality: social cost = private cost + external cost.
- Positive externality: social benefit = private benefit + external benefit.
- If external costs are ignored, the market price is too low and the quantity produced is too high.
- A Pigouvian tax can correct a negative externality by making the price reflect the external cost.
- A subsidy can encourage activities with positive externalities by lowering the effective cost to buyers or producers.
Vocabulary
- Externality
- An externality is a cost or benefit from a transaction that affects someone who is not the buyer or seller.
- Negative externality
- A negative externality is a harmful spillover effect, such as pollution, noise, or traffic congestion.
- Positive externality
- A positive externality is a helpful spillover effect, such as vaccination, education, or neighborhood beautification.
- Social cost
- Social cost is the total cost to society, including both private costs and external costs.
- Pigouvian tax
- A Pigouvian tax is a tax placed on an activity with a negative externality to make the market price reflect its full social cost.
Common Mistakes to Avoid
- Confusing external costs with normal production costs is wrong because wages, rent, and materials are paid by the firm, while external costs fall on third parties.
- Assuming all externalities are negative is wrong because some activities create spillover benefits, such as education improving civic participation and worker productivity.
- Thinking the market price always shows the true cost is wrong because prices may leave out pollution, health damage, congestion, or other third party effects.
- Treating a tax as only punishment is wrong because a well designed Pigouvian tax can help align private choices with the true social cost.
Practice Questions
- 1 A factory sells a product for 15 per unit, and pollution causes an external cost of $4 per unit. What is the social cost per unit, and how much of the cost is missing from the market price if the price only reflects private cost?
- 2 A city estimates that each car trip creates 1 in air pollution costs for others. If a commuter takes 40 trips per month, what is the total monthly external cost created by that commuter?
- 3 A homeowner plants trees that shade the sidewalk, improve air quality, and make the street more attractive. Explain whether this is a positive or negative externality, and describe one policy that could encourage more of this behavior.