What is an externality? Costs and benefits that fall on others

An externality is a cost or a benefit of an activity that falls on people who aren't part of the decision and aren't paid or charged for it. A factory's smoke that harms the neighbors' lungs is a negative externality; a neighbor's vaccination that lowers your risk of catching a disease is a positive one. Because the decision-maker ignores effects that land on others, markets produce too much of activities with external costs and too little of those with external benefits.

In short

• An externality is an effect on a third party that no price reflects: pollution, noise and congestion are costs; vaccination, pollination and new ideas are benefits.
• When a cost falls outside the deal, buyers and sellers trade more than they would if they paid the full cost.
• The main fixes are a tax on the harm, a capped number of tradable permits, direct rules, and bargaining between the parties, each with real strengths and weaknesses.

What are negative and positive externalities?

A market works well when the people making a choice bear its costs and receive its benefits. An externality breaks that link. The idea goes back to the British economist Alfred Marshall in the 1890s and was developed by Arthur Pigou in The Economics of Welfare in 1920, as Wikipedia's account of the concept traces.

	Negative externality	Positive externality
What spills over	A cost	A benefit
Examples	A factory's smoke; a loud party; a car adding to a traffic jam	A vaccination; a neighbor's well-kept garden; a beekeeper whose bees pollinate nearby orchards
Who decides	The polluter, driver or host	The person vaccinated, the gardener, the beekeeper
What the market does	Produces too much	Produces too little

The vaccination case is worth slowing down on. When you're vaccinated, you lower your own risk, which you weigh. You also make it less likely that you pass the disease on to others, which you may not. If enough people are vaccinated, those who can't be are protected too. Each person's choice counts only part of its benefit, so left alone, fewer people are vaccinated than would be best for everyone, which is one reason governments subsidize vaccines or provide them free.

Why does a market overproduce pollution? A worked example

Take the market for a chemical whose factories release smoke. Each tonne's smoke does $30 of damage to people nearby, in health costs and dirty homes, which nobody charges the factories for. To keep the numbers small, take a market of just five tonnes.

Tonne	What buyers will pay for that tonne	Factory's cost of making it	Plus $30 of smoke damage: full cost to society	Gain or loss to society
1st	$100	$20	$50	+$50
2nd	$90	$30	$60	+$30
3rd	$80	$40	$70	+$10
4th	$70	$50	$80	−$10
5th	$60	$60	$90	−$30

Step by step:

1. What the market does. Factories make each tonne buyers will pay at least its production cost for. That's all five: the fifth sells for $60 and costs $60 to make. The market produces 5 tonnes at a price of about $60.
2. What would be best. Count the smoke too. The third tonne is worth $80 and costs society $70, so it's worth making. The fourth is worth $70 but costs society $80. The best quantity is 3 tonnes.
3. The damage. The fourth and fifth tonnes together make society $40 worse off ($10 + $30), even though buyers and sellers were each happy with their trades. The trades were good for the people in them and bad for everyone else.
4. A fix. A tax of $30 a tonne, equal to the damage, raises the factories' cost to the full social cost. Now only the first three tonnes cover their cost, the price rises to between $70 and $80, and output falls to the efficient 3 tonnes. The tax also raises $90 (3 tonnes × $30), which could compensate the neighbors or replace other taxes.

That tax is a Pigouvian tax, after Pigou. The key point is that the problem isn't selfishness. It is that the price leaves something out, so the people responding to it, as everyone responds to incentives, respond to the wrong signal.

How can governments fix an externality?

There are four main approaches, and economists argue over which fits which case. OpenStax's Principles of Economics sets out the market-based ones alongside direct regulation.

Approach	How it works	The case for it	The case against it
Pigouvian tax	Charge a fee per unit of harm, ideally equal to the damage	Polluters cut wherever it's cheapest; raises revenue; supported by many economists	The right rate is hard to know; the total amount of pollution isn't fixed; new taxes are politically hard
Cap and trade	Set a total limit, issue permits for it, let firms buy and sell them	Fixes the total; firms that can cut cheaply sell permits to those that can't	Permit prices can swing; giving permits away free can reward past polluters; the cap may be set too loose
Regulation	Rules on technology or emission limits per plant	Simple to check; certain for the worst harms, such as toxic substances	Same rule for every firm, so cuts aren't made where they're cheapest; can slow better technology
Coase bargaining	Define who has the right, and let the parties negotiate	No government budget needed; works for small, local cases	Breaks down when many people are affected and bargaining is costly

The last row comes from Ronald Coase's 1960 paper "The Problem of Social Cost." Coase argued that if property rights are clear and bargaining is cheap, the parties will reach the efficient outcome on their own, whoever holds the right. He also argued, as Wikipedia's article on the Coase theorem notes, that real bargaining costs are rarely low enough for this to work when many people are involved. Nobody can negotiate with every resident of a city about its air.

The bees show bargaining at work on a small scale. Economists long used beekeepers and orchards as a textbook positive externality; in the early 1950s James Meade proposed subsidizing apple orchards for the benefit they gave beekeepers. Then Steven Cheung's 1973 case study, "The Fable of the Bees," found that beekeepers and orchard owners in Washington State already wrote detailed pollination contracts, as Bryan Caplan's encyclopedia entry on externalities recounts. Where the parties are few and can find each other, they often solve the problem themselves.

Has cap and trade worked?

The best-known test is the US Acid Rain Program, set up under the 1990 amendments to the Clean Air Act to cut sulfur dioxide from power plants, the main cause of acid rain. It began in 1995, and the Environmental Protection Agency describes it as the country's first national cap-and-trade program, with a final cap set in 2010 at 8.95 million tons, about half of the power sector's 1980 emissions. The EPA counts it a success, and many economists cite it as evidence that tradable permits can cut pollution at lower cost than uniform rules. The European Union's Emissions Trading System, begun in 2005, applies the same idea to carbon dioxide.

Still argued

Climate change is the largest externality economists study: each tonne of carbon dioxide adds to warming felt worldwide and for generations, and the emitter pays none of that cost, which is why the economist Nicholas Stern's 2006 review for the UK government called it the greatest and widest-ranging market failure ever seen. Many economists favor putting a price on carbon, by tax or by permits, as the cheapest way to cut emissions. Others argue that regulation, subsidies for clean technology, or public investment are more workable politically, or better at speeding new technology, and that carbon prices fall hardest on poorer households unless the revenue is returned. Estimates of the damage from each tonne, the "social cost of carbon," vary widely with assumptions about the future. This note sets out the options; it doesn't recommend one. What is climate change? covers the science.

Where do externalities lead next?

Externalities are one kind of market failure, a case where prices alone don't lead to the best use of scarce resources. Two close relatives build on the same idea. A public good, such as national defense or a lighthouse, has benefits so widely shared that nobody can be charged for them, so markets supply too little. And when a shared resource like a fishing ground is free to use, each user's catch imposes a cost on the others, the tragedy of the commons.

Check yourself

• In the chemical example, why does the market produce 5 tonnes when 3 would be best for society?
• How does a $30 tax per tonne bring output down to the efficient level?
• Why does Coase bargaining work for bees and orchards but not for a city's air?

Sources

• 12.1 The Economics of Pollution — OpenStax, Principles of Economics 3e, 2022
• 12.3 Market-Oriented Environmental Tools — OpenStax, Principles of Economics 3e, 2022
• Acid Rain Program — U.S. Environmental Protection Agency
• Externalities — Bryan Caplan, Concise Encyclopedia of Economics, Library of Economics and Liberty, 2008
• Externality — Wikipedia
• Coase theorem — Wikipedia