In economics, externalities are indirect costs or benefits of economic activities on uninvolved third parties.
When a third party is affected by an externality, they get a benefit or suffer from something that arose from an economic activity they weren’t involved in.
Governments and social institutions sometimes take actions to deal with (“internalize”) externalities (Stewart & Ghani, 1991 & Jaeger, 2012, p. 80). The most common method is the imposition of taxes on producers of externalities.
The problem is that it is especially difficult to have all the information about externalities, so it is hard to impose the right taxes.
A negative externality, also known as an external cost or an external diseconomy, is an economic activity that imposes a negative effect on an unrelated third party.
Just like a positive externality, it can result from the production or consumption of a good or service. In other words, a negative externality is anything that causes an indirect cost to individuals.
For example, toxic gasses released from mines or industries cause harm to uninvolved third parties such as the individuals within the surrounding area.
Air pollution in general imposes health and clean-up costs on entire societies (Manisalidis et al., 2020), despite the fact that not every member of that society is heavily involved in it. As such, activities that cause air pollution are negative externalities (Droste-Franke et al., 2005).
Pollution is considered an externality because it imposes costs on people who are “external” to the producer and consumer of the product (Goodstein & Polasky, 2014, p. 32). As the list of examples below shows, many negative externalities are similarly related to environmental consequences of production and consumption.
20 Negative Externality Examples
- Climate change: As a consequence of greenhouse gas emissions, anthropogenic climate change is a negative externality that imposes costs on the entire world, which includes uninvolved third parties. According to several scholars, not only is climate change a negative production externality, but also “the greatest example of market failure we have ever seen” (Stern et al., 2007).
- Deforestation: We log forest for wood necessary for building houses. However, the removal of forests can have negative impacts such as the loss of rare remove habitats for wildlife and endangered species. Furthermore, forest like the Amazon act as carbon sinks; once they’re gone, climate change will be sped up.
- Eutrophication: Eutrophication refers to the increasing levels of nutrients in a water body. While this may appear positive, it can lead to growth of unwanted plants such as algae, which can poison the water for local animals. It also depletes the levels of oxygen in the water.
- Habitat destruction: Urban development and the expansion of agricultural lands can destroy natural habitats. This forces animals further away from their natural habitats and may cause species conflicts, among other negative externalities.
- Habitat fragmentation: Building highways has amazing benefits for industry, but highways cut migration paths for animals, making it difficult for them to maintain their natural migration patterns.
- Invasive species: When people introduce non-native species into a locale, it throws out the balance of the ecosystem. For example, the introduction of domestic cats in semi-rural areas leads to loss of native birds that the cats prey upon.
- Meat eating: Most humans eat meat, but some people highlight the negative externalities of this practice – including animal pain and suffering.
- Noise pollution: Noise may impose unwanted costs on uninvolved third parties. An example of this would be sleep deprivation due to airplane noise.
- Overfishing: If there is not strong regulation of fishing (such as quota caps and rotation of fishing locations), the fish population may drastically dwindle, which affects not only the fish but their predators.
- Overuse of water: In Australia, upstream use of water on the Murray-Darling river has led to droughts and salination downriver, which has decimated the ecosystem. It also prevents downriver farmers from having access to water.
- Overworking: A husband who wants to make more money for his family works extra hours in the workplace. But there’s a negative externality of this: his wife gets upset that he doesn’t spend time with her, and his children don’t see him enough.
- Ozone depletion: The release of chlorofluorocarbons (CFCs) led to what came to be known as the “hole in the ozone layer”. The ozone later was beneficial for keeping out harmful UV rays and regulating temperatures. This hole has been linked to increased skin cancers.
- Pesticide use: Pesticides used to keep pests away from crops or even keep out snakes from your home can have negative impacts on non-target species, such as birds and bees.
- Pollution: When a factory produces products for consumption, it may also produce negative side effects in the form of pollution. We seen this from the smoke stacks out the top of many factories. These smoke stacks may release toxic chemicals that end up in the air, water, and soil. This can negatively impacting the health and quality of life of nearby residents as well as the whole local ecosystem.
- Price increases: Intense consumption of a product causes the price of that product to rise, thereby making other consumers worse off. This might prevent, reduce, or delay the consumption of others. This is, outside of being a negative externality, a pecuniary externality (Liebowitz & Margolis, 1994).
- Soil erosion: Overgrazing of cattle leads to soil erosion which may mean grass can no longer grow in the area and the zone becomes less lush and more like a desert landscape.
- Spam emails: The sending of unsolicited messages by email is an example of a negative production externality. According to Justin Rao and David Reiley, “American firms and consumers experience costs of almost $20 billion annually due to spam” (Rao & Reiley, 2012).
- Systemic risk: The risks taken by the banking system can have negative consequences for entire economies.
- Traffic congestion: Driving to work is convenient and sometimes our only choice. But when too many vehicles are using the same road at the same time, we end up with traffic congestion and traffic jams. This can cause delays and inconvenience for all drivers, meaning it’s an externality for all.
- Waste disposal: If people throw waste down the drain instead of putting it in a bin or recycling, that waste may end up in the ocean and cause harm and even death to animals like dolphins and turtles.
- Water pollution: The reduction of the quality of water by industrial activities can bring harm to uninvolved third parties such as plants, animals, and humans.
Types of Externalities
There are two main types of externalities: positive and negative. A negative externality leads to unintended negative consequences; a positive externality leads to unintended positive consequences.
- Negative Externality Example: water pollution affects all consumers but is not caused by them. Water pollution is, therefore, a negative externality.
- Positive Externality Example: A positive externality, on the other hand, benefits the third party. For example, if someone plants trees in the garden below your apartment, you might receive the benefits of being closer to nature and getting more shade.
In addition, there are other types of externalities:
- positional or pecuniary externalities
- inframarginal externalities, and
- technological externalities.
Positional or pecuniary externalities are those which affect a third party’s profit but not their ability to consume or produce (Frank, 2011).
Inframarginal externalities are those which don’t benefit or harm the marginal consumer. Such externalities have an inframarginal effect, so they don’t require policy action (Liebowitz & Margolis, 1994).
Technological externalities directly affect a firm’s production and thereby affect the individual’s consumption. As the name suggests, the concept refers to externalities caused by technology.
The concept of externalities was first developed by two British economists: Henry Sidgwick (who was also a famous utilitarian philosopher) and Arthur Cecil Pigou (1961).
Sidgwick first articulated the idea of spillover costs and benefits, but Pigou was the one who formalized the concept.
To illustrate the concept, Pigou used the example of sparks from a railway engine. The sparks could ignite surrounding farmlands, which would destroy crops. Farmers would thereby pay the cost created by the sparks of a railway engine (McConnell et al., 2009).
Externalities are the positive or negative consequences of activities on unrelated third parties. The positive effects that arise as a result of economic activities are called positive externalities. Negative effects of the same kind are called negative externalities. Let’s consider the examples of each type of externality in turn.
As an example of a positive production externality, Ilan Elgar and Christopher Kennedy discuss public transport. Public transport can increase economic welfare by providing transit services for unrelated economic activities. The benefits of those economic activities don’t affect the operator, making this an example of a positive production externality (Elgar & Kennedy, 2005).
A familiar example of a negative externality is passive smoking. If I don’t smoke, but others smoke around me, an activity I’m not a part of harms me.
The cost, in this case, is physical harm. Exposure to secondhand smoke may cause disease, disability, and death (IARC, n.d.). Economists often categorize passive smoking as a moral hazard as well as a negative consumption externality.
An externality is an indirect cost or benefit to an uninvolved third party that results from the activities of an involved party. There are two main types of economic externalities: positive and negative. A negative externality is an externality that imposes a cost to the uninvolved third party. Any type of externality can occur on the production or consumption side. There are several ways in which governments and institutions deal with or internalize externalities, including a range of economic incentives and social policies.
CE Delft, Directorate-General for Mobility and Transport (European Commission), Essen, H. van, Fiorello, D., El Beyrouty, K., Bieler, C., Wijngaarden, L. van, Schroten, A., Parolin, R., Brambilla, M., Sutter, D., Maffii, S., & Fermi, F. (2020). Handbook on the external costs of transport: Version 2019 – 1.1. Publications Office of the European Union. https://data.europa.eu/doi/10.2832/51388
Droste-Franke, B., Bachmann, T., Greßmann, A., Rabl, A., Hunt, A., Markandya, A., Tol, R., Hurley, F., Navrud, S., Hirschberg, S., Burgherr, P., Heck, T., Torfs, R., Nocker, L. D., Vermoote, S., Panis, L. I., & Tidblad, J. (2005). ExternE: Externalities of Energy : Methodology 2005 Update. Office for Official Publications of the European Communities.
Elgar, I., & Kennedy, C. (2005). Review of Optimal Transit Subsidies: Comparison between Models. Journal of Urban Planning and Development, 131(2), 71–78. https://doi.org/10.1061/(ASCE)0733-9488(2005)131:2(71)
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Manisalidis, I., Stavropoulou, E., Stavropoulos, A., & Bezirtzoglou, E. (2020). Environmental and Health Impacts of Air Pollution: A Review. Frontiers in Public Health, 8. https://www.frontiersin.org/articles/10.3389/fpubh.2020.00014
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Rao, J. M., & Reiley, D. H. (2012). The Economics of Spam. Journal of Economic Perspectives, 26(3), 87–110. https://doi.org/10.1257/jep.26.3.87
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