Externality | Types & Solution

Externality

An externality is a cost or a benefit imposed upon a third party by the production or consumption of a good. Externalities exist when the activities of one or more agents affect the welfare of other agents and the welfare of other agents was not considered in decisions determining the level of activity. Externalities are types of market failure. An externality is a cost or benefit that is experienced by someone who is not a party to the transaction that produced it. Under an externality, market prices do not reflect true marginal costs and/or benefits associated with the goods or services created by the activity when they are traded in the market. Externalities lead to suboptimal outcomes. Externalities may be positive or negative.

Negative Externality:

Negative externalities arise when an action by an individual or group produces harmful effects on others. Pollution is a negative externality. Let us assume a paper producing firm located near a residential plot and a river. The paper producing industry pollute the environment in the neighborhood by realizing toxic air in to the atmosphere and waste effluent in to a river stream. When a factory discharges its untreated effluents in a river, the river is polluted and consumers of the river water bear costs in the form of health costs or/and water purification costs. In an activity generating negative externality, social cost is higher than private cost i.e., MSC>MPC.

Figure 1

The graph shows the effects of a negative externality. For example, the paper industry is assumed to be selling in a competitive market. The marginal private cost (MPC) is less than the marginal social cost (MSC) by the amount of the external cost (MEC), i.e., the cost of air pollution and water pollution. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.

If the consumers only take into account their own private cost, they will end up at price P and quantity Q, instead of the more optimal and efficient price P^* and quantity Q^*. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, that is that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result is that a free market is inefficient since at the quantity Q, the MSC is greater than MPC, so society as a whole would be better off if the goods between Q and Q^* had not been produced. Even if the producer choose to produce at Q, the firm should take in to account both MPC and MEC and charge a higher price at P₁.The problem is that people are buying and consuming too much paper.

When a negative externality occurs the marginal social cost (MSC) will be higher than the marginal private cost (MPC) or price and hence the private optimal level of output will be higher than the social optimal output.

Positive Externality:

Positive externality arises when an action by an individual or a group confers benefits to others. A technological spill over is a positive externality and it occurs when a firm’s invention not only benefits the firm but also enters into the society’s pool of technological knowledge and benefits the society as a whole. In an activity generating positive externality, social benefit is higher than private benefit, i.e., MSB>MPB.

Figure 2

The graph shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit (MPB) of getting the vaccination is less than the marginal social benefit (MSB) by the amount of the external benefit. This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume there are no external costs, so that social cost equals individual cost.

If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price P and quantity Q, instead of the more efficient price P^* and quantity Q^*. These latter reflect the idea that the marginal social benefit (MSB) should equal the marginal social cost (MSC), i.e., that production should be increased as long as the marginal social benefit (MSB)exceeds the marginal social cost (MSC). The result in an unfettered market is inefficient since at the quantity Q, the social benefit (MSB) is greater than private benefit (MPB), so society as a whole would be better off if more goods had been produced. The problem is that people are buying too few vaccinations.

When a positive externality occurs, the marginal social benefit (MSB) will be higher than the marginal private benefit (MPB) or price and hence the private optimal output will be lower than the social optimal output.

Types of Negative and Positive Externalities:

1. Negative production externality: When a firm’s production reduces the wellbeing of others who are not compensated by the firm.

2. Negative consumption externality: When an individual’s consumption reduces the well-being of others who are not compensated by the individual.

3. Positive production externality: When a firm’s production increases the wellbeing of others but the firm is not compensated by those others.

4. Positive consumption externality: When an individual’s consumption increases the well-being of others but the individual is not compensated by those others.

Solution to Externalities: Pigovian Tax and Subsidies

Pigovian Tax/ Corrective Tax:

A Pigovian tax is a tax levied on any market activity that generates negative externalities i.e., costs not internalized in the market price. The tax is intended to correct an inefficient market outcome, and does so by being set equal to the social cost of the negative externalities. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. An often-cited example of such an externality is environmental pollution.

Figure 3

Let us assumed a paper producing industry causing negative externality. The government can achieve this outcome of internalizing the externality by taxing the paper producer an amount MEC for each unit of paper produced. The figure above illustrates the impact of such a tax. The paper market is initially in equilibrium at point E, where supply (MPC) equals demand (D=MB), and Q units of paper are produced at price P. Given the externality with a cost of MEC, the socially optimal production is at point E^*, where social marginal costs (MSC) and benefits (MB) are equal.

Suppose that the government levies a tax per unit of paper produced at an amount t = MEC. This tax would act as another input cost for the paper producer, and would shift its private marginal cost up by MEC for each unit produced. This will result in a new curve i.e., SMC which is equal to MPC+MEC. As a result, the tax effectively internalizes the externality and leads to the socially optimal outcome (point E^*, quantity Q^*). This type of corrective taxation is often called “Pigovian taxation,” after the economist A. C. Pigou, who first suggested this approach to solving externalities.

Pigovian Subsidy/ Corrective Subsidy:

A Pigovian subsidy is a subsidy that is used to encourage behaviour that have positive effects on others who are not involved or society at large. Behaviors or actions that are a benefit to others who are not involved in the transaction are called positive externalities. Pigovian subsidies are closely related to Pigovian taxes, and are typically provided by governmental or regulatory bodies.

Figure 4

Not all externalities are negative, in cases such as industry supplying smallpox vaccinations, externalities can be positive. The government can internalise this externality by making a payment, or a subsidy, to the industry supplying vaccinations. The amount of this subsidy would exactly equal the benefit to the other industry and would cause the producers to produce more vaccinations since his cost per vaccine has been lowered. The impact of such a subsidy is illustrated in Figure, which shows once again the market for vaccination. The market is initially in equilibrium at point E where MC = PMB, and Q of vaccine are produced at price P. Given the positive externality with a benefit of MEB, the socially optimal production is at point E^*, where marginal social costs (MSC) and benefits (MSB) are equal.

Suppose that the government pays a subsidy per quantity of vaccine produced of Subsidy = MEB. The subsidy would lower the marginal cost of vaccine production, shifting the marginal cost curve down by MEB for each unit produced. The subsidy has caused the market moves from a situation of underproduction to one of optimal production. This type of corrective subsidy is often called “Pigovian subsidy,” after the economist A. C. Pigou, who first suggested this approach to solving externalities.