Introduction to Externalities

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When making the claim that free, unregulated markets maximize the amount of value created for a society, economists either implicitly or explicitly assume that the actions an choices of producers and consumers in a market don't have any spillover effects onto third parties who are not directly involved in the market as a producer or a consumer. When this assumption is taken away, it no longer has to be the case that unregulated markets are value-maximizing, so it's important to understand these spillover effects and their impacts on economic value.

Economists call effects on those not involved in a market externalities, and externalities vary along two dimensions. First, externalities can be either negative or positive. Not surprisingly, negative externalities impose spillover costs on otherwise uninvolved parties, and positive externalities confer spillover benefits on otherwise uninvolved parties. (When analyzing externalities, it's helpful to keep in mind that costs are just negative benefits and benefits are just negative costs.) Second, externalities can be either on production or consumption. In the case of an externality on production, the spillover effects occur when a product is physically produced. In the case of an externality on consumption, the spillover effects occur when a product is consumed. Combining these two dimensions gives four possibilities:

Negative Externalities on Production

Negative externalities on production occur when producing an item imposes a cost on those not directly involved in producing or consuming the item.

For example, factory pollution is the quintessential negative externality on production, since the costs of pollution are felt by everyone and not just those who are producing and consuming the products that are causing the pollution.

Positive Externalities on Production

Positive externalities on production occur when producing an item confers a benefit on those not directly involved in producing or consuming the item.
For example, there is a positive externality on production in the market for fresh-baked cookies, since the (presumably pleasant) smell of baking cookies can often be experienced by people not involved in the baking or the eating of the cookies.

Negative Externalities on Consumption

Negative externalities on consumption occur when consuming an item actually imposes a cost on others. For example, the market for cigarettes has a negative externality on consumption because consuming cigarettes imposes a cost on others not involved in the market for cigarettes in the form of second-hand smoke.

Positive Externalities on Consumption

Positive externalities on consumption occur when there is a benefit to society of consuming an item above an beyond the direct benefit to the consumer of the item. For example, a positive externality on consumption exists in the market for deodorant, since wearing deodorant (and therefore not smelling bad) confers benefits on others who are perhaps not themselves consumers of deodorant.

Because the presence of externalities makes unregulated markets inefficient, externalities can be viewed as a type of market failure. This market failure, at a fundamental level, arises because of a violation of the notion of well-defined property rights, which is in fact a requirement for free markets to function efficiently.

This violation of property rights occurs because there are is no clear ownership of air, water, open spaces, and so on, even though society is affected by what happens to such entities.

When negative externalities are present, taxes can actually make markets more efficient for society. When positive externalities are present, subsidies can make markets more efficient for society. These finds are in contrast with the conclusion that taxing or subsidizing well-functioning markets (where no externalities are present) reduces economic welfare.