What Are Externalities? How to Reduce Negative Externalities

Externalities occur when the production or consumption of a good affects a third party who is not directly involved in the market exchange. These effects can be either positive (like more job opportunities in a government-subsidized business sector) or negative (like health problems directly resulting from environmental pollution related to a company’s production efforts).

Externalities typically occur in industries such as energy or public health and often have economic and social costs (such as a damaged environment or socioeconomic imbalance). Government regulation and taxation are standard methods to discourage activities with negative external effects. Still, the affected companies often raise the prices of their goods to recoup the fiscal cost, which either discourages consumption or makes it unsustainable.

Economists and government bodies evaluate the two main types of externalities—positive and negative—by examining the market outcomes, transaction costs, and potential social benefits or consequences of consuming or producing a particular good. Here is a breakdown of how regulating bodies will evaluate the different types of externalities.

• Positive consumption externalities: Evaluating positive consumption externalities involves comparing how the consumption of a good affects consumers and producers and its effect on society's overall well-being. In other words, the external benefits of a good’s consumption must outweigh the private benefits.
• Positive production externalities: If a private entity’s production process yields more benefits than consequences for the external affected parties, it is a positive production externality. This type of externality involves the private cost of production outweighing its social cost.
• Negative consumption externalities: Negative consumption externalities involve the private benefits of consumption outweighing the overall social consequences.
• Negative production externalities: These externalities involve private production efforts that have consequences for the social welfare of the third party.

From an economic perspective, a positive externality occurs when the private-sector production efforts or consumption of goods has positive effects on a third party. Here are a few examples of positive externalities.

1. 1. Education: Companies that train their employees in special skills yield positive externalities in the workforce. These skilled employees will be able to take their specialized skills to other companies in the market economy, resulting in a more competent and effective workforce.
2. 2. New technology: New advancements in technology can have positive spillover effects in the overall market, like making the production processes for a particular industry cleaner, more efficient, and cost-effective. This newfound efficiency allows companies to keep their prices low, providing economic benefits to consumers who can spend less money to purchase goods and services.
3. 3. Renewable energy: Wind and solar power are two forms of renewable energy that have a higher benefit for society, offsetting the cost of production. While the technology takes capital to build and operate, these methods create clean, renewable energy sources to offset environmental pollution and its related health consequences for human beings.

Negative externalities are spillovers—external costs—to a third party through production or consumption. Some examples of negative externalities include:

1. 1. Antibiotic resistance: An example of a negative externality is the increase in the number of antibiotic-resistant strains of certain viruses caused by ubiquitous antibiotic usage in modern medicine. The development of these viruses can lead to a surge in illness and death amongst the population—a greater human cost than the economic activity that the production and consumption of the drug created.
2. 2. Factory production: Companies may be motivated to use cheaply operating factories that keep costs low but cause high pollution levels. The negative side effects on the environment—along with the people and animals who inhabit it—can be devastating, from health complications to air pollution that causes trees to die. Even if the company running the factory can produce lots of goods quickly and cheaply, the social cost can be greater than the private benefit.
3. 3. Traffic congestion: The market value of a car typically does not include negative effects such as the cost of time wasted sitting in traffic jams or the effects on the air quality caused by carbon emissions. Burning fuel releases harmful elements like carbon dioxide, a greenhouse gas that contributes to global warming, which hastens climate change.

It’s possible to offset negative externalities in many different ways.

1. 1. Community outreach: Negative externalities often affect impoverished and at-risk communities. Helping vulnerable populations access basic healthcare necessities or food resources can reduce sickness—keeping premiums low and increasing access to healthcare—and improve public health.
2. 2. Government intervention: Taxation, regulation, and stronger environmental policies are three ways the government policymakers can discourage negative externalities and prevent market failure. Creating laws, restrictions, and extra costs for particular modes of production (such as an improvement in dumping laws or fines for water cleanup) requires companies to find alternative, low-social cost ways of producing their goods.
3. 3. Green farming technology: Policymakers may provide subsidies for companies developing technological advancements in organic or green farming methods. These subsidies may help reduce water pollution and the number of harmful chemicals and pesticides in the crops that carry carcinogens and other toxins. They may also lower environmental costs—like diseases caused by these substances—over time.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by the world’s best, including Paul Krugman, Doris Kearns Goodwin, Ron Finley, Jane Goodall, and more.