- Externalities occur when producing or consuming a good cause an impact on third parties not directly related to the transaction.
- Externalities can either be positive or negative. They can also occur from production or consumption
Positive Externality in Production
A farmer grows apple trees. An external benefit is that he provides nectar for a nearby beekeeper who gains increased honey as a result of the farmers’ orchard.
In this case, the social cost is less than the private cost. The beekeeper saves the cost of having to provide a source of nectar.
In this example, it works both ways. The beekeeper provides an external benefit to the apple grower because his bees help to fertilise the apple tree.
Negative Externality in Production
Making furniture by cutting down rainforests in the Amazon leads to negative externalities to other people. Firstly it harms the indigenous people of the Amazon rainforest. It also leads to higher global warming as there are fewer trees to absorb carbon dioxide.
The social cost of making furniture is greater than the private cost to a firm.
Positive Externality in Consumption
Education. If you take a three-year training course in information technology, you gain personal skills, but also other people in the economy can benefit from your knowledge. The social benefit from consuming education is greater than your personal benefit.
Negative externality in consumption
If you smoke in a crowded room, other people have to breathe in your smoke. This is unpleasant for them and can leave them exposed to health problems associated with smoking.
The social benefit is less than the private benefit.
Pigou on Externalities
In 1920, Arthur C. Pigou wrote The Economics of Welfare which is an early exposition of this concept
Pigou noted that private business pursued their own marginal private interests. However, industrialists were not concerned with any external costs to others in society. In other words, they had no incentive to internalise the full social costs of their actions and this led to a deadweight welfare loss.
Pigou used an example of a contractor building a factory in the middle of a neighbourhood. The factory leads to external costs faced by those living in the locality. These external costs include:
- Damage to health
- Loss of light
Pigou also used the example of alcohol. Alcohol has a private benefit to firms but also the sale of alcohol leads to additional costs to society in terms of increased demand for healthcare and law and order.