Externalities – Meaning, Types, Causes, Consequences and Solutions

Introduction to Externalities

Since time immemorial, good human values require every person to be considerate of their neighbor as they go about their daily activities. Thus before carrying out an activity of any type – socio-economic or otherwise – one should ask what impact, negative or otherwise, this activity is likely to have on a third party within the proximity of the environment and beyond. This gives rise to externalities.

This is a topic that should be of interest to everybody because no one lives on an island. Externalities exist because we all live in some environmental context and our activities invariably have an effect on it, no matter how small. Thus the topic on externalities.

Externalities
Externalities

Definition of Externality

An externality may be defined as a consequence of an economic activity that is experienced by unrelated third parties. It is therefore important to appraise your environment and consider who or what is in it and what activities take place in it. Try to relate these to the activities in the diagram below.

If you are in business in this environment, you may not be the only one. Activities of others that affect your operations are external to your internal activities. Just find out how population growth in the environment in which your business operates influences your business growth. What about the socio-cultural activities of the population on your business.

You can go on and on examining how economic, political, legal technological and global activities affect your business operations and growth. These activities are in your environment just as you and your business are in the same environment. Ask yourself how they affect you or how your activities affect theirs and explore any need to cooperate with the others for mutual optimal outcomes.

Types of Externalities

An externality can be a cost or a benefit to a third party resulting in either a negative or positive outcome.

Negative Externalities

Let us look at a few examples of negative externalities to deepen our understanding.

Pollution is one of the most ubiquitous negative externalities. Examples include emissions of toxic gases and effluents from factories, dumping of garbage in undesignated places by factories and homes and so on. These activities not only create eyesores but also pose serious health hazards to residents in the neighborhood.

Negative externalities
Negative externalities

A cattle herder who cannot control his animals and lets them loose to feed on flowers and crops of neighbors becomes a nuisance and a statistic of negative externalities. Think of the university and college students who wreak havoc on innocent motorists as a way of ventilating their anger. Instead of directing it at the university administration, with whom they have grievances, they end up hurting people who have nothing at all to do with their issues. This is clearly uncalled for and bespeaks of a people who have no compassion for their neighbors.

Large aircrafts taking off or landing emit loud noise which in some cases causes stress and creates fear in residents of neighboring estates. It means that nobody cared about location considerations at the design stage of the airport or airstrip. The government could probably have considered relocating the residents or reconsidered the location of the landing zone depending on who occupied first.

Examples of negative externalities abound in our environment and we could go on and on.

Positive Externalities

Let us start by asking a few questions to help us understand positive externalities.

  • Does your family benefit from a carpentry workshop in the neighborhood?
  • Does a maize farmer benefit from a slaughter house in the neighborhood?

Who of the parties benefits from the other in the neighborhood – the maize farmer or the bee farmer, the dairy farmer or the livestock farmer? Your answers are as right as mine.

If we all became aware of how each person’s activities affect their neighbors, and acted responsibly, we all would be a happier lot.

Take another look of a well-educated and trained population and neighborhood from which a company draws its workforce. This company will enjoy benefits of high productivity and low industrial strife. Such workers are likely to be good time managers and diplomatic in case of any industrial dispute hence a source of industrial peace in the work environment. What a blessing!

Imagine you were using demand and supply curves in your analysis of negative and positive externalities and started from a market equilibrium position when all resource allocations were optimal, answers to the following questions would add great values to your stock of knowledge in the subject area – I can bet that if you try them and go wrong, you will not be penalized.

Assuming unchanged demand (ceteris paribus) for the product of the producer, what impact would a negative externality have on the producer’s supply curve? The price he will charge for what he sells?

Keen observation would show that that an externality to a producer or supplier would force him to produce and supply less causing his supply curve to shift inwards to the left. As a result of this, Market Quantity Equilibrium falls. By extension, this would cause the Market Equilibrium Price to rise. Guess who would suffer most between the suppliers and the consumers of this product because of the externality.

Now take a case of a positive externality. Assuming a state of unchanged demand for the product, a positive externality would confer benefits of reduced production costs on the producer. As a result of this, guess what would happen to the producer’s supply curve, his market equilibrium point, market equilibrium quantity and his market equilibrium price.

Don’t forget to ask yourself who between the consumer and the producer of this product would benefit most. Justify your argument for the position you have taken in this case.

The positive externality which has caused a reduction in production costs for a product has induced the producer to hire more factor inputs for more production of the good. Given that demand for the product remained unchanged, increased supply of the product caused by an outward shift in supply curve would cause the equilibrium price to fall. This will greatly benefit the consumers as their welfare would be enhanced.

Causes of Externalities

An externality arises when a person engages in an activity that influences either adversely or otherwise the wellbeing of a bystander. In this case, neither the source of the externality pays nor is compensated by the recipient of the externality nor is recipient of the externality paid or compensated for the effect of the externality. When a market outcome affects parties other than the buyers and sellers in the market, side-effects created are called externalities. Externalities cause markets to be inefficient and thus fail to maximize total surplus or profits to producers. To consumers, total utilities from the use of a product affected by an externality may be less or more than is socially desirable because the externality has resulted into production that is either less or more than socially desirable.

Efficient Free Market

If there were no market failures, the market price mechanism would operate through free forces of Supply and Demand to facilitate optimal resource allocation. In such situations, we would be living in a Utopian World. In such a world, each product would have many buyers and sellers where none would have domineering influence in the market. Such a product would be technically and economically homogeneous. The buyers of the product in this market as well as suppliers of the product would be all knowledgeable of the market situation and would not rely on any influence through advertisements and other inducements to buy or produce a good. All participants in such a market enjoy zero transport costs as if located at the same point. Of course, only a single uniform unit price prevails in the whole market for the product.

You can imagine a market in which not even a trace of government influence or directive is heard of. In such a wonderful market, the producers will freely enter the market and partake of the super-normal profits. They would enjoy the same freedom to vacate the market if evidences abound that firms in the market reap only losses. Of course each firm would evaluate if it generates revenue above or at or below its variable costs in the light of losses before taking a decision to quit or continue producing and selling. In such a market, optimal resource allocation would be achieved when producers charge a price equal to the firm’s Marginal Costs.

Market Failures and Externalities

From the typical utopian market alluded to above, we can guess with much confidence what a failed (or call it an imperfect) market would look like. In such a market:

There would be fewer buyers and fewer sellers, this number going as low as one on both sides. Here you will meet a monopsonist who takes pride for being the sole buyer of a commodity or factor. He pays the lowest price below his marginal costs but justifying the use of marginalism principles in setting his price to exploit the seller of the product or factor. In his neighborhood, you will come across a monopolist bragging to be the only seller of a product, fleecing the consumers with impunity.

Yes! In an imperfect product or factor market you will enter a market gate and meet heterogeneous or differentiated products or factors, the reasons for which traders will justify charging price differentials because each seller enjoys some degree of monopoly.

Once you hear of a monopolist or a monopsonist or their monopolistic competitors, you would be sure of restricted mobilities into or out of a factor or product market. The monopolist will even show you why he would charge different prices for different buyers for the same quantities of the same product.

This will be because he can segment his product market into income blocks. Of course he will never charge marginal cost price just as his friend the monopsonist would not pay the marginal wage rate for labor or marginal interest rate for capital or marginal rent rate for land that he buys.

In an imperfect market, both consumer and producer ignorance abound, made worse by powerful advertisements whose contents may not make the buyer any better.

Existence of economies of scale in the hands of a few by virtue of natural or acquired or illegally purchased) endowments renders buyers prone to exploitation. Sometimes, it may not be surprising to find impunity and law of the jungle operating in a market where there is a failed administrative, judicial and police systems. In such a situation, aggrieved buyers or sellers do not get justice.

Solutions to Externalities

How would externalities arise in such situations of failed market systems? Cases of environmental degradation – on water, in the air and on land – are a common sight. Charcoal burners and sand harvesters continue to benefit at the expense of the environment and the community at large.

In the case of a negative externality, it is only fair that a party that suffers consequences should be adequately compensated either directly or indirectly by the source of the externality. Similarly, a party that benefits from a positive externality should feel obligated to reciprocate in some way.

The extent of the damage or benefit of the externality in question should have a way to be measured. This will make it possible to determine the amount of penalty to be paid by the source of the negative externality and extent of compensation to the party that suffers from it.

Similarly, it will make it possible to determine how much the beneficiaries from positive externalities need to cough out to subsidise the source of this externality. The bee farmer definitely benefits from the Maize farmer and so does the Maize farmer benefit from the bee farmer. The two can be good friends absorbing the effects of the externalities without requiring any compensation from each other.

It is very important that every government should have a clear and effective public policy on externalities to promptly deal with the problems of externalities. When externalities are significant and private solutions are possible, the government should through relevant Acts of Parliament, regulations and by-laws prohibit or regulate activities that cause harmful externalities.

These could come in the form of command-and-control policies or market-based policies applicable to firms, individual producers and consumers. Those who fail to comply should face the full force of the law.

Because the effects of externalities generated in an area or a country or a region may spill over to the neighboring countries, part of solutions to deal with such externalities must include inter-governmental or regional cooperation and policy integration.

Use of fiscal measures such as taxes to deter negative externalities and subsidies to encourage positive externalities has been quite effective. When an anti-pollution law or regulation has specified a maximum limit of waste discharge, any firm exceeding this limit may be forbidden from continuing the excess discharge or may be prosecuted and fined appropriately or may be instructed to install pollution abatement equipment or otherwise stop its activities all together.

Think of cases where activities of a firm generate positive externalities in a community’ such as the construction of a cattle dip. This would definitely reduce incidences of tick borne diseases. More milk and healthy beef would also follow as a result. The owner of such a cattle dip needs to be compensated by way of charging some amount to the users.

In both cases, externalities would have been internalized. The Coase Theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own and allocate resources efficiently.

If the victim of an externality can negotiate with the source of externality on how the effect of the externality can be minimised, the better. What negotiation can you have with your neighbour who always arrives back home drunk and very noisy in the dead of the night?

If negotiation fails, an alternative course of action can be resorted to. Either the source of externality can be sued in court for being a public nuisance or the victim can move out of the place to a more convenient area.

When these options fail, the Law of the Jungle is unfortunately likely to be applied whereby the source of the harmful externality will be forcefully ejected out of the particular environment.

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