Jeff Butcher
Rachel Hill

Postive and Negative Externalities

An externality is defined as a benefit or cost that is imposed on a third party, such as society, other than the producer or consumer of a good or service, or, more simply, an economic side effect. The more of a product that is consumed or produced, the more of an externality that results. When discussing externalities in general terms, positive externalities refer to the benefits and negative externalities refer to the costs associated with the production or comumption of a good or service.

Externalities are not ususally fully reflected in prices. Externalities are regarded as a form of market failure. The costs and benefits related to externalities are not typically included as part of the decision to complete the economic activity. Given this, the chosen volume or frequency of activity is not directly related to the externality and becomes an inefficiency in terms of resource use. Negative externalites cause too much of a product to be produced and positive externalities cause too little of a product's production. When considered as a supply-demand graph for a positive externality, the marginal benefit curve perceived by the decision maker will be to the left of the marginal benefit curve of society. This shows too little activity taking place.

Public goods are one of the more common examples of positive externalities. Public goods are goods which are difficult to exclude people from benefiting from or from getting a free ride. Public goods, such as national defense, clean water, clean air, law enforcement, etc., are generally good for most, if not all of society.

Negative externalities exist in many situations. One of the most common examples is that of pollution. In these situations, the producer and consumer finance the goods produced but society must bear the cost of pollution that is introduced into the environment as a by-product and is thus a negative externality. For example, a factory that produces widgets generates a hazardous by-product from the widget production process. It dumps the by-product in neighboring stream. The more widgets produced, the more by-product is produced and thus the more pollution that goes into the water. The factory may bear some of the cost of the pollution but not all. Any remaining cost is borne by society. In this situation and in the event of the absence of well defined property rights there may be an issue of how much pollution may be dumped into the water or if it can be dumped into the water at all plus an issue over who is responsible for the cost of the pollution. In the absence of well defined property rights, it may be necessary for the government to step in to introduce regulation, legislation, taxes, etc. to address the situation. An example where the government addressed an issue was the Clean Air Act.

Examples of Externalities

Positive externality:
  1. Immunizations, such as a flu shot, etc., provide a positive externality to third parties in that it helps prevent the spread of illness in the general public.
  2. A company provides funds for it's employees to obtain specialized training or degrees. By doing so, the company can be benefited by increased production which also benefits the customer. At the same time, this can benefit society as a whole by increasing the level of education, quality of life, etc.
  3. Significant home improvements will not only raise a person's property value, but it will also increase the values of the home nearby.
  4. Improving driving habits will decrease the risk of accident for everyone on the road as well as eventually reduce insurance premiums of the driver.

Negative externality:
  1. Pollution from a factory can cause health problems and erode the quality of life and property values in a community.
  2. A power plant that burns coal to generate electricity emits pollution. The more electricity that is demanded by customers, the more coal that is burned in order to produce it. Increasing the amount of coal burned to generate electricity thus increases the level of pollutants emitted into the atmosphere that can lead to such things as global warning, acid rain and smog.
  3. Second-hand cigarette smoke causes health problems in people other than smoker.
  4. A loud party next door can cause those not involved in the festivities to lose sleep.

Test Questions:
1. True or False: A particular lumber company overharvesting trees in a particular area and thus greatly reducing the amount of available resources to other lumber companies is an example of a positive externality.

2. Giving flu shots to school aged children creates what form of externality for the ederly?
a) Negative Externality
b) Equal Externality
c) Positive Externality
d) None of the above

3. Costs experienced by an uninvolved third party in the consumption or production of a good are referred to as:
a) Positive Externalities
b) Negative Externalities
c) Isocosts
d) Social Costs

4. Benefits expereienced by uninvolved third party in the consumption or production of a good are referred to as:
a) Positive Externalities
b) Negative Externalities
c) Isocosts
d) Social Costs

5. True or False: A factory dumps its by-products into a nearby river thus polluting the body of water. The factory fails to provide an efficient leve of output due to the absence of well-defined property rights.

1. False
2. c
3. b
4. a
5. True

Class Notes ECON 509, Ball State University, Fall 2006
Tucker, Irvin B. Survey of Economcis 5e. Mason, OH:Thomson South-Western, 2006. 76-77
Baye, Michael R. Managerial Economics and Business Strategy.New York: McGraw Hill, 2006.518-520