Externalities are costs or benefits that are not reflected in the price of a good or service, but instead are borne by society as a whole. In other words, externalities are unintended consequences of economic activity that affect people who are not directly involved in that activity.
There are two types of externalities: positive and negative. Positive externalities occur when the consumption or production of a good or service creates benefits for individuals or society that are not reflected in the price. For example, education creates positive externalities because an educated person contributes to the economy and society as a whole. Negative externalities, on the other hand, occur when the consumption or production of a good or service creates costs for individuals or society that are not reflected in the price. For example, pollution from a factory creates negative externalities because it harms the health of nearby residents.
Externalities can lead to market failure because the price of a good or service does not reflect its true social cost or benefit. This can result in too much or too little of the good or service being produced or consumed. Governments can intervene in the market to correct for externalities by implementing policies such as taxes, subsidies, and regulations. These policies aim to internalize the external costs or benefits and bring the market price closer to the true social cost or benefit.
Examples of externalities:
- Positive externality: Vaccinations. When individuals get vaccinated, not only do they protect themselves from disease, but they also protect others by reducing the spread of the disease. This benefit to society is not reflected in the price of the vaccine.
- Negative externality: Traffic congestion. When too many cars are on the road, it leads to traffic congestion which causes delays, increased pollution, and decreased productivity. These costs are not reflected in the price of driving.
- Positive externality: Beekeeping. Bees not only produce honey, but they also pollinate crops which benefits the farmers and the entire ecosystem. This benefit is not reflected in the price of honey.
- Negative externality: Noise pollution. When a factory or an airport produces excessive noise, it can disturb the peace and quiet of nearby residents, impacting their well-being. This cost is not reflected in the price of the products or services produced by the factory or airport.
- Positive externality: Education. When individuals get educated, they contribute to the economy by being more productive and creating innovations. This benefit is not fully reflected in the price of education.
- Negative externality: Smoking. When individuals smoke, they not only harm their own health, but also expose others to second-hand smoke, which harms their health as well. This cost is not reflected in the price of cigarettes.