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.
There are two main types of externalities: positive and negative. For example, water pollution affects all consumers but is not caused by them. Water pollution is, therefore, a negative externality.
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.
Governments and 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.
A positive externality (also called “external benefit” or “beneficial externality”) is anything that results from an economic activity and causes a benefit to an uninvolved third party for which the producer of that externality is not compensated (Varian, 2019).
For example, if my neighbors fire-proof their homes, the risk of my house catching fire is reduced. There are two types of positive externalities: those that occur on the production side and those that occur on the consumption side.
A positive production externality occurs when a firm’s production benefits others but the firm is not compensated by those it benefits.
A positive consumption externality, on the other hand, occurs when an individual’s consumption benefits others but the individual is not compensated by those others (Gruber, 2019).
- Gentrification increases your house price: A house that is especially attractive and pleasing may confer economic benefits to the neighbors. Being located near an architectural landmark, for example, may increase the market value of surrounding houses (Samwick, 2007). The owners of the neighboring houses thereby receive a benefit as a result of an activity they aren’t involved in.
- Beekeeping and native plant pollination: A beekeeper may keep bees for their honey, but keeping bees in a territory has a positive side effect. The positive externality associated with this is the pollination (the transfer of pollen from an anther of a plant to the stigma of a plant) of surrounding crops. This enables fertilization and the production of seeds. As such, this positive production externality may be more valuable than the honey produced by the bees.
- Other people getting a college degree and increased quality of life: Living near highly educated people can confer important benefits to uninvolved third parties. Improved education can lead to greater economic productivity, a lower unemployment rate, better jobs, greater household mobility, higher rates of political participation, and many other positive outcomes for everyone (Weisbrod, 1964).
- Environmentally friendly actions: Your decision to recycle or simply use the trash can has positive externalities for uninvolved third parties. A clean environment is beneficial to all inhabitants, not just those who take action to make it so.
- Fire protective neighborhood: Fireproofing a house confers benefits to the surrounding houses. The neighboring properties, as a result of this positive externality, are less at risk of the neighbor’s fire spreading to their unprotected house.
- Historic building restoration and economic value: The restoration of historic buildings has the same effect as a landmark. It increases the economic value of nearby properties and encourages more people to visit the area. Because of this, such restorations can also confer economic benefits to surrounding businesses. The restoration of historic buildings, therefore, gives rise to all sorts of positive production externalities.
- Bakeries spreading their great smell: If someone opens a bakery on the first floor of an apartment building, the people living in the apartment above receive the benefit of enjoying the smell of fresh pastries every morning. They also benefit from the fact that a bakery is so close to where they live (Gruber, 2019). These are examples of positive externalities that affect an uninvolved third party as a result of the economic activities of others.
- Network externalities (and economies of scale): If others buy a product that is interconnected in a network, that can confer external benefits to you. For example, the fact that many other people own the same smartphone as you, granted that that smartphone is embedded in a certain network, may increase the value or usefulness of your smartphone. This phenomenon, when each new user of a product increases the value of the same product owned by others, is called a network externality or a network effect and it is classified as a positive consumption externality.
- Research and development leading to unintended inventions: The benefits of the conducted research are more often conferred to uninvolved third parties than the researchers or originating firms themselves.
- Vaccines and herd immunity: Anything that reduces the rate of transmission of an infectious virus confers benefits to uninvolved third parties. Positive consumption externalities can, therefore, arise from vaccines, quarantines, testing, hygienic measures, the use of face masks, improved sanitation, and other public health measures. Even if someone isn’t vaccinated, they still receive the benefit of a lowered risk of infection if other people are vaccinated. This is, therefore, an example of a positive consumption externality.
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 tobacco 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.
Other Types of Externalities
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.
Origins of the Concept
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).
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 positive externality is an externality that causes a benefit 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, most commonly by imposing taxes.
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)
Frank, R. (2011). Are Positional Externalities Different from Other Externalities?
Gruber, J. (2019). Public Finance Public Policy. Macmillan Learning.
IARC. (n.d.). Tobacco Smoke and Involuntary Smoking. Retrieved December 17, 2022, from https://publications.iarc.fr/Book-And-Report-Series/Iarc-Monographs-On-The-Identification-Of-Carcinogenic-Hazards-To-Humans/Tobacco-Smoke-And-Involuntary-Smoking-2004
Jaeger, W. K. (2012). Environmental Economics for Tree Huggers and Other Skeptics. Island Press.
Liebowitz, S. J., & Margolis, S. E. (1994). Network Externality: An Uncommon Tragedy. The Journal of Economic Perspectives, 8(2), 133–150.
McConnell, C. R., Brue, S. L., & Flynn, S. M. (2009). Economics: Principles, Problems, and Policies. McGraw-Hill/Irwin.
Pigou, A. C. (1961). The Economics of Welfare. Transaction Publishers.
Samwick, A. (2007). Economist’s View: What Pecuniary Externalities? https://economistsview.typepad.com/economistsview/2007/01/what_pecuniary_.html
Stewart, F., & Ghani, E. (1991). How significant are externalities for development? World Development, 19(6), 569–594. https://doi.org/10.1016/0305-750X(91)90195-N
Varian, H. R. (2019). Intermediate Microeconomics: A Modern Approach. W. W. Norton, Incorporated.
Weisbrod, B. A. (1964). External Benefits of Public Education. Industrial Relations Section, Department of Economics, Princeton University.