Externalities

Externalities Meaning

Externalities refer to the cost or benefit experienced by an entity without producing, consuming, or paying for it. It implies that this indirect cost or benefit affects an entity other than its producer or consumer.

It can be either positive or negative. For example, if it takes the form of cost, it is a negative effect; if it emerges in the form of benefit, it is an exhibition of a positive impact. Furthermore, externalities in economics play a significant role in many economic growth theories.

• Externalities are the cost or benefit caused by the production or consumption of any product or service by a third party outside the system.
• It can be a positive or negative effect caused by production or consumption. So there exist positive consumption, negative consumption, positive production, and negative production externalities.
• The effect can be neglectable or serious, affecting an individual, organization, or society.
• If the effect causes serious harm, then government intervention occurs through policies like fuel taxes to reduce and discourage such activities.

Externalities Explained

Externalities are positive or negative indirect outcomes caused by production or consumption activities. Every day, millions of production and consumption activities are taking place. The producers and consumers may or may not be aware of their activity's indirect effect on an unrelated third party. In the long run, it can reduce shareholder returns and damage the environment.

Its effect can be smaller, larger, or more serious, affecting an individual, organization, or society. Unfortunately, when it comes to organizations, these indirect costs are generally not recorded in the balance sheet.

If the effect spilled is of serious concern, then generally, there are policies to address it like fuel taxes, fuel economy and emissions standards, congestion tolls, and alternative fuel policies. This way, it may discourage activities causing negative side effects to unrelated parties and create awareness about the long-term detrimental effect of certain productions and consumptions among economic actors.

Positive Externalities

It occurs when economic activity performed by an entity benefits an unrelated entity or third party. Also, the third party is different from the producer, and the consumer is not liable to pay for the benefits to anyone. It can be due to production or consumption. It implies that both production and consumption activities can positively affect unrelated parties. For example, infrastructure development positively influences local businesses, and people attaining education contributes to forming a well-educated society and its positive after effects.

Negative Externalities

They are the opposite of positive externalities; here, the impact and influence of certain economic activities harm the environment and society. The benefit obtained by the private entity performing the economic activity is greater than the social benefit, sometimes, there is no social benefit, and it only harms society. In some ways, capitalism and a capitalistic mindset can be observed as a reason for negative externalities. In day-to-day lives, more negative externalities can be seen in the world. The whole global warming and climate change issue can be defined as an externality caused by humans' usage of electronics and electrical appliances, cars, industrial gases, garbage released into the environment, etc.

Examples

• A company manufactures packaged drinking water. The product has a huge customer base composed of travelers, party organizers, event planners, restaurants, and people who buy it out of immediate thirst. Therefore, the company is manufacturing the product on a large scale. However, other than the cost obtained by the producer, the packaged drinking water production and consumption creates external costs in the form of environmental pollution contributed by the improper treatment of plastic waste and waste from the manufacturing plant.
• Peter is a full-time employee, and his office is 4km from his apartment. He has a car, but he always walks to his work. This decision and act of Peter walking to the office not only works on his health but contributes to the environment by reducing traffic congestion, air pollution, and noise pollution. Hence, it creates a positive impact.
• Certain products are liked and demanded by people, but there is always a downside, either ignored or less thought of. For example, a man with the habit of smoking may find it amusing. Still, when he smokes in public places, the passive smoking experienced by other people around him is the downside of cigarette smoking that is less thought of.
• A girl plants as many trees as possible on her land. It positively impacts the environment, other nearby people, birds, etc. They may not readily experience it, but it will positively impact them in the long run.

Frequently Asked Questions (FAQs)

Recommended Articles

This has been a Guide to Externalities and their definition. We explain its meaning in economics, examples, causes, and positive and negative externalities. You may learn more from the following articles –

• Network Externalities
• Corporate Social Responsibility
• Impact Investing