Economic Externalities and How to Deal with Them

In economics, one of the main areas of study is environmental economics. Economic scholars and experts have established that there is a direct link between economic development and the environment. It is believed that economic development has a negative impact on the natural ecology, leading to the loss of ecological systems.

We live in a world when human needs are unlimited, and the natural resources expected to feed these needs are limited. The economy requires the availability of the resources used as raw materials in creating the required products. And these materials come from the environment. This is where the issues of scarcity come. There are never enough resources to go around, and the little left is supposed to protect the environment.

Environmental economics deals with the impacts of economic activities on the environment. It has been established that the best way to protect the environment truly would be to cease economic development, which is not possible. Therefore, we can only do this by creating policies and regulations against the excessive use of natural resources.

Another aspect of environmental economics is failed markets. This is when markets fail to effectively allocate the limited resources available for creating economic progress and profits. In market failure, we find externality as a subject of study under the economics of the environment.

In this discussion, we are going to define externalities, types, causes, and solutions. Students taking economics at higher levels of education must undertake this course because it helps then understand the best way to protect our natural resources while ensuring proper economic growth at the same time. It is the responsibility of every human being to protect the environment because negative externalities like pollution and hazards negatively impact the environment.

What Is an Externality?

Human beings are defined in economics as social beings and rational decision-makers. This means we are faced with decisions on a daily basis, which we have not a choice but to make. Every choice has consequences, mostly effective other people around us positively and negatively. The relationship between producers and consumers in a market setting creates a perfect economic environment. In this case, firms and households are often faced with decisions they must make, which has an impact on the economies. When an individual or a firm takes a choice that affects another person without any sense of accountability, an externality will exist.

We can define externality as a cost or benefit of an economic activity experienced by a third party not directly related to the activity being undertaken. The external cost or profit does not appear in the final cost or benefit of the good or service. For this reason, economists consider externalities a serious issue that can cause serious problems on markets by causing inefficiency, leading to failures of these markets. They are also viewed as the main fuel behind the Tragedy on the commons. An externality is a cost or benefit that impacts a third party who did not agree to take part in the activity that caused the effect.

An externality exists when the product or consumption of a good or service's private price equilibrium does not represent the true cost of the said product's benefits for the whole society. This means the firm's economic activity failed to allocate limited resources in a manner that is seen fit to society. The result of this case is the competitive externality equilibrium not to be Pareto optimality.

In most cases, externalities are seen as negative effects, although they can also be positive. Governments and institutions take actions of internalizing externalities, and hence, market-priced transactions can take into account all the benefits and cost linked with the transaction between economic agents. This happens mostly when tax is not imposed, and so when the externality reaches a certain level, it attracts a very high tax. Poorly designed taxation laws can be the main cause of externalities on commons. Since regulators don't always have all the information on the externality, it becomes hard to impose the right tax. A competitive equilibrium becomes a Pareto optimal at the point where an externality is internalized through tax imposition. 

Consider, for instance, manufacturing firm activity that causes air pollution. Such activities concerned parties can come up with health and clean-up costs for the whole society. On the other hand, the neighbors of households who choose to use fireproofing technology on their homes may enjoy the benefits of reduced fire risks spreading to their homes. Where external costs pollution exists, the causing party may choose to produce more of the product than would be required in the case where they would be required to pay all associated environmental costs. Note that the responsibility of a consequence lies partly outside the self, and hence, an element of externality is existent. Where there are benefits of external benefits, like public safety, the maker many produce fewer goods than that they would if they were to receive compensation for the external benefits to others. In other words, an externality may either benefit the doer at the cost of society or benefit society at the doer's cost. To understand these statements, we say that the overall cost and benefit to society is the sum of the monetary value of the benefits imposed and the cost of all parties involved.

Externalities is not a new concept as it began with British economists who have credited with the initiation of the study of externalities in the formal institutions. It was referred to as the "spillover effects." Henry Sidgwick (1838-1900) discussed the first person to articulate the issues while Arthur C Pigou (1877 – 1959) formalized the concept. Today, the word externality is applied because the effects produced on others, whether positive or negative, it external to the market.

A negative externality is any difference existing between the private cost of the activity or decision and its cost to society. This means a negative externality is anything that may cause an indirect cost to the individual. For instance, industries realized toxic gases into the environment, which may harm people living within their reach, and hence, they are burdened to a cost (indirect) of getting rid of the harm. If the air is badly polluted from firm fumes or water is contaminated from mines, it may cause sicknesses to the factory's societies. These individuals are faced with a decision to either continue living in silence as they suffer or stop the pollution. Either way, there is still a cost they have to incur. On the other hand, a positive externality exists are a difference between the private gain of the decision to the economic agents and its benefit to society. Simply put, a positive externality is that effects positively indirectly. For instance, if an individual plants trees, they will make their property look beautiful, and it will also be cleaning the air in the areas around, which is beneficial to a society indirectly.

Sometimes there exists voluntary exchange, which is mutually beneficial to both parties because they would not agree to take any decision if it were not to best of their interest. But then, these are two parties who understand what is happening, and they have an agreement. However, this transaction can stretch its effects into the line of a third party who may not have any knowledge or consent to it. Looking at it from this perfective, the effects may come as bad – pollution from factory operation nearby, or as good – honey bees kept by a firm for honey can pollinate neighboring crops.

According to neoclassical economists, where plausible conditions exist, externalities will appear as a result of the outcomes that are not optimal to societal expectations. Sufferers from external negative effects bear the cost involuntarily, while those who reap the benefits do so at no extra cost. If there are external costs to voluntary exchange, it may lead to a reduction in social welfare. An individual suffering from negative impacts of an externality due to air pollution looks at it as a lowered utility. It is either subject to displeasure or the high costs they will be forced to incur, such as high medical bills.

An externality can even be considered a trespass on these individuals' lungs, which is in violation of their property rights. Since the Pareto efficiency underpins the justification for private property, negative externalities are inefficient to it. They do not conform to the whole idea of market economies, and this why they are seen to cause more problems than positive ones.

Negative Externalities

Any economic activity that imposes a negative effect on an unrelated third party is called a negative externality or external cost. It can come from the production or consumption of the product. For instance, pollution is seen as an externality because it imposes costs on people who are not related (external) to the producers. They don't have any mutual agreement that this production will beneficial to both or either of the parties. Many of these negative externalities are related to the consequences of production and use on the environment. When a firm carries out production activities without considering environmental concerns, they are imposing such costs to a society that may not have had anything with the production process or any agreements to this effect.

Types of negative externalities include:

Air pollution

Air pollution is the most common form of externalities. It arises from a wide range of sources, especially from burning fossil fuels. This action can damage crops, materials, and historic buildings, apart from public health.

Anthropogenic climate change

One of the biggest issues being looked at in terms of sustainable development under global goals is global warming. This is a result of greenhouse gas emissions from the burning of fossil fuel. These gasses affect the ozone layer, which shields hash UV lights from hitting the earth. Economists of climate change have often raised concerns that these changes present a huge challenge to the environment, as it is the best example of a market failure.

Water pollution

When industries release their waste into rivers, it becomes harmful to plants, animals, and humans. Using water from growing plants can have a negative effect on citizens of states who are affected by deceased water.

Noise pollution

Noise pollution occurs during production, which may lead to loss of hearing. It can also be mentally and psychologically disruptive.  

Other types of negative externalities

Negative externalities are visible in a wide range of human activities. Spam during the sending of unsolicited messages by email cause the same risk. There is also a systemic risk to the general economy emerging from the risks that banking systems take. A moral hazard can occur in the absence of well-designed banking regulation or a poor system.

The negative effect of industrial farm animal production, which includes the surge in antibiotic-resistant bacteria due to too much use of antibiotics, is similar. This also includes air quality issues, the contamination of rivers, streams, and coastal waters dues to concentrated animal waste.

Overfishing leads to the depletion of fish stock in the ocean and instance of common property resources. This leads to the Tragedy of the commons, where appropriate environmental concern does not exist.

The cost of storing nuclear waste from nuclear plants for over 1000 years in the USA has been included in the cost of electricity produced by the plant in the form of a fee paid to the government and stored in nuclear waste superfund.

Passive smoking, second-hand smoke, and overuse of antibiotics are listed as negative consumption externalities. They all lead to a negative result, which should lead to negative economic growth.

Positive externalities

Examples of positive externalities include been keepers who keep their bees for honey, which could also help in pollination. Consider also when an industrial company offers free first aid classes of employees to improve their job safety. Restored historic sites, and a foreign firm demonstrating up-to-date technologies to a local firm as a way to improve productivity, are all under positive externalities.

Conclusion and solution

Both negative and positive externalities have adverse effects on market efficiency. Therefore, policymakers and economists come up with different solutions to these issues. It is generally done through government intervention by properly defining property rights, imposing heavy taxes on goods that cause externalities, and providing subsidies to stimulate specific actions. 

Author: James Hamilton