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Reviewed by Annapoorna | Updated on Jan 05, 2021


What are Externalities?

Externality, a term used in economics, refers to the costs incurred or the benefits received by a third party, wherein such a third party does not have control over the generation of the costs or benefits.

The externality can be positive or negative and may arise from the production or consumption of goods or services. It can be either private or social, i.e. affecting within the organisation or the entire society, respectively.

Externalities may be classified as positive or negative. Accordingly, an externality might not affect the organisation that causes the externality.

A demonstration of the negative externality is the pollution that is emitted by a factory which disturbs the surrounding environment and affects the health of nearby residents. An example of a positive externality is the influence of a well-educated workforce on a firm's productivity.

Externalities often happen when the production or consumption of the own price equilibrium of a product or service can not reflect the actual costs or benefits of that product or service for the society as a whole. The difference leads to an inequality of competitive equilibrium of externality with that of Pareto Optimality.

Understanding Externalities

If external costs, such as pollution, exist, the producer may choose to produce a higher quantity of the product than would be made if the producer were required to pay all the environmental costs associated with that.

Since responsibility or consequence for self-directed action lies partly outside of self, an externalisation element is involved. The overall cost and benefit towards the society are described with a formula. It is the sum of the imputed monetary worth of benefits and costs to all the parties involved.

Implications of Externalities

Neoclassical welfare economics asserts that the existence of externalities will result in outcomes which are not socially optimal under plausible conditions. Those suffering from external costs do so involuntarily, while those benefiting from external benefits do so at no cost.

If external costs do exist, a voluntary exchange may reduce social welfare. Thus, an external cost could pose an ethical or political issue. Negative externalities are generally Pareto inefficient. Since Pareto efficiency underlies private property justification, they pull down the entire market economy. Due to these reasons, negative externalities are more problematic than positive externalities.

Positive externalities, while maintaining an efficient Pareto, are still market failures. With no government, these undermine the allocative efficiency because lesser goods will be produced than in a theoretical model which is optimal for society on the whole. If these externalities were internalised, the manufacturer would be encouraged to provide more.

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