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Correcting for Externalities Definition
What is the definition of externalities? In economics, externalities are defined as unintended consequences of a transaction or an activity. These spillover effects indirectly benefit or harm a third party. The third party, in this case, is not involved in a transaction or activity that caused the externality in the first place.
Air pollution is something all of us are equally affected by. Imagine a student who doesn't even drive a car and cycles or walks to school every day. They may not even be a direct cause of air pollution compared to someone who travels by car everywhere they go.
Pollution is a classic example of a negative externality, pixabay
Externalities are unintended consequences of a transaction or an activity that indirectly benefits or harms a third party.
Externalities and market failure
Externalities are one of the sources of market failures alongside other factors. These other factors are inadequate information and competition, resource immobility, and public goods.
Learn more on this topic in our article - Market Failures!
But how exactly do externalities contribute to market failure? Externalities cause market failure because the market prices do not reflect the indirect costs or benefits to the whole society. This results in less efficient economic outcomes as producers and consumers choose sub-optimal decisions from a societal point of view. This distortion in decision-making is what ultimately results in market failures. The free market will produce too much of a negative and too little of a positive externality.
The factory polluting the air on the outskirts of the city does not compensate you for having a lower air quality you breathe in daily.
The factory that opened on the city's outskirts generated jobs and income for the families of the newly employed workers. The factory owner does not share the additional profit generated from this enterprise directly with you.
Correcting Externalities: Types of Externalities
There are two types of externalities. But before we get into this, let's recall what externalities are.Externalities are unintended consequences of a transaction or an activity that indirectly benefits or harms a third party. But these consequences can be positive as well as harmful.If positive indirect effects occur from a transaction or an activity, it is called a positive externality. A negative externality arises if adverse indirect effects arise from a transaction or an action.
Positive and negative externalities examples
Let's go over some examples of positive and negative externalities.
Imagine your neighbor regularly mows their lawn, plants flowers, and paints their fence and house with fresh paint every year. Doing so benefits the whole neighborhood as it makes the entire area look pretty.
Imagine your neighbor leaves trash outside their house, doesn't plant grass and flowers, doesn't sweep their territory, and doesn't paint their home and the fence. They indirectly cause adverse effects to the whole neighborhood as their derelict house with junk lying around looks like an eye sore.
An electric power plant near a local river can enjoy cost savings from easy access to large amounts of water. These cost savings reduce the unit price of energy for consumers in the local region, thereby improving its affordability.
The same electric power plant can dispose of the waste in the river. The wastewater pollution results in the fish population declining in the area. Local fishermen now have fewer fish and are struggling to earn income to support their families.
Positive externalities are indirect positive effects of a transaction.
Negative externalities are indirect negative effects of a transaction.
Government Intervention to Correct Externalities
Government intervention is often required to correct externalities. Think of the pollution externality example of a power plant polluting a local river. Unless the government intervenes, the plant will continue polluting because it generates the most profits for them. Local residents living away from the river and not impacted by pollution would support the lower energy cost that the power plant provides. This would encourage the plant to continue its activities in the same way.What possible solutions can the government implement to tackle negative and positive externalities? Let's go over each of them in turn!
Correcting negative externalities
How can the government correct negative externalities? As there is usually too much of a negative externality, the government needs to try and reduce this amount. It can do so by imposing a tax on a firm that produces a negative externality.Consider Figure 1 below.
Figure 1. Optimal tax to correct a negative externality, StudySmarter Originals
Figure 1 above shows how the government can correct a negative externality by imposing a tax. The initial equilibrium is at the intersection of the demand curve (D) and the supply curve (S0). The tax increases production costs for a firm, shifting its supply curve to Stax. The equilibrium shifts from (P0, Q0) to (Pc, Qtax). This eliminates the inefficiency or a deadweight loss depicted by the red-shaded triangle. The government collects a tax revenue equal to the purple-shaded area.If the intervention is optimal, then the tax per unit will equal the cost of the negative externality per unit. The new price will reflect this particular good's actual cost to society. The efficient quantity will then be produced and consumed.
Measuring the exact cost to society that a negative externality causes is complex. That is why the resulting outcome of government intervention often brings the market towards the optimum outcome but does not precisely reach it.
Correcting positive externalities
How can the government correct positive externalities? As there is usually too little of a positive externality, the government needs to try and increase this amount. It can do so by providing a subsidy to a firm whose production exhibits a positive externality.Consider Figure 2 below.
Figure 2. Optimal subsidy to correct a positive externality, StudySmarter Originals
Figure 2 above shows how the government can correct a positive externality by providing a subsidy. The initial equilibrium is at the intersection of the demand curve (D0) and the supply curve (S). The subsidy allows the consumers to demand more at each price level, shifting the demand curve from D0 to Dsubsidy. The equilibrium shifts from (P0, Q0) to (Pp, Qsubsidy). This eradicates the inefficiency or a deadweight loss represented by the red-shaded triangle. The government incurs a subsidy expense equal to the yellow-shaded area.
If the intervention is optimal, the subsidy per unit will equalize the benefit of the positive externality per unit. The new price will reflect this particular good's actual benefit to society. The efficient quantity will then be produced and consumed.Like costs, measuring the benefits to society that a positive externality can provide is problematic. That is why the resulting outcome of government intervention often brings the market towards the optimum equilibrium but does not always achieve it.
Correcting for externalities examples
Let's go over two practical examples of how the government corrects positive and negative externalities in the real world.
Consider a negative externality of emissions in a congested part of a city from cars that run on gasoline. The excessive amount of vehicles causes congestion, pollution, and noise in excessive amounts. Local residents are suffering from all these indirect costs. Clearly, the cost of driving in the center of the city is too low. The government can impose a congestion charge that would make cars pay a fee if they cross a certain threshold to enter this area. This would reduce the number of vehicles that enter the central city, thereby reducing a negative externality.
Consider the benefits that education brings to the whole population. A higher level of education reduces crime rates, promotes economic growth through employment, and improves the standard of living. That is why governments in many countries across the globe partially or fully subsidize the cost of public education. Primary and secondary education is almost free in most countries, with some higher education institutions offering considerable price reductions for high achievers.
Creating a market for negative externalities
Another solution implemented by governments across the globe is creating a market for negative externalities. A great example is tradable emission permits adopted due to the Clean Air Act of 1990. While the total emissions are capped, the factories can utilize the free market to trade these emission permits. The factories that are less efficient in pollution reduction would have to spend more to acquire those permits. In contrast, the more efficient factories can trade these permits for money. The free market mechanism allows permits to be allocated to the entities that value them the most. They provide incentives for reducing emissions and allow for certain flexibility to reduce pollution in the most feasible way, thereby eliminating the negative externality.
Correcting Externalities - Key takeaways
- Externalities are unintended consequences of a transaction or an activity that indirectly benefits or harms a third party.
- Positive externalities are indirect positive effects of a transaction.
- Negative externalities are indirect negative effects of a transaction.
- Government intervention is often required to correct externalities. Negative externalities are corrected by taxes, while positive externalities are corrected by subsidies.
- A classic example of a negative externality is pollution. A classic example of a positive externality is the benefits of education. Alternative methods such as creating a market for negative externalities are employed to tackle the externality problem.
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Frequently Asked Questions about Correcting Externalities
How can we solve the problem of externalities?
Governments can solve the problem of externalities by providing subsidies or imposing taxes.
What are the two main ways to deal with externalities?
The two main ways to deal with externalities are taxes and subsidies.
What are the policies to deal with externalities?
The policies to deal with externalities include imposing taxes on polluters and subsidizing education.
What are externalities and their types?
Externalities are unintended consequences of a transaction or an activity that indirectly benefits or harms a third party. There are two types of externalities: positive and negative.
How can the government correct externalities?
The government can correct externalities by estimating either the external cost or benefit. It then needs to impose a tax equal to the external cost or provide a subsidy equal to an external benefit.
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