What Is An Externality?
Definition: Externality is a term used in finance to denote the cost or benefit incurred by an unrelated third party. Externalities occur from the production of goods and services that end up impacting third parties that are not directly related. Similarly, an externality can be negative or positive.
The fact that the affected third party has no control over an externality is one of the reasons why it is never reflected as a final cost or benefit in the preparation of financial statements. Consequently, economists view these costs or benefits as problems that make markets inefficient.
Types of Externalities
Negative Externality
A negative externality refers to a negative outcome of an economic output that affects an unrelated third party resulting in adverse effects. While most externalities are negative, they are often divided into two.
Negative production externalities are adverse effects that arise from the production of goods. Air pollution, which arises from the burning of fossil fuels, ends up affecting people living in the surrounding as well as workers.
Water pollution is also a typical production externality that occurs whenever a tanker spills oil that ends up affecting wildlife in the sea as well as people consuming the water. Noise pollution also amounts to a production externality that affects people living near airports or nightclubs.
Consumption externality is the other type of negative externality that arises from the consumption of goods. For instance, smoking not only affects the person consuming the cigarette but people in the surrounding as well.
Positive Externality
Positive externality amounts to benefits that third people incur from various economic activities. Likewise, these benefits can be distinguished as either production or consumption externality.
Positive Production Externality
Construction of vital infrastructures such as roads, schools and shopping centers goes a long way in benefiting real estate owners and agents. Property prices tend to rise as more people move into neighborhoods. Likewise, a company that discovers a new technology ends up creating new benefits that may end up benefiting the entire society.
Positive Consumption Externality
Increased education levels in an area go a long way in raising the economic productivity of the area, consequently leading to the development of business, which in return reduces unemployment levels. Likewise, vaccination not only benefits the person vaccinated but the community at large as it averts cases of infection.
Externalities Solutions
Economists and policymakers have formulated a wide array of solutions for addressing the various forms of externalities known to affect market efficiency. Formulation and implementation of policies that limit the effect externalities have since come into play. Some of the policies include:
Taxation
Governments and local authorities are increasingly imposing huge taxes on companies that produce goods that result in environmental pollution. The charges are designed to discourage activities that may result in water or air pollution that end up affecting people.
Likewise, some authorities do force polluters to pay compensation to people affected as a way of curbing such incidences in the future. The tax, in this case, should be equal to the cost of the externality to discourage any incidences that result in a net cost to third parties in future
Subsidies
The offering of subsidies by local governments to companies that rely on efficient process of production has also helped curb production externalities. Such subsidies have seen companies limit emissions to the environment.
Subsidies have also gone a long way in encouraging the consumption of goods with positive externalities. Such subsidies may be directed to people who plant fruit trees that go a long way in providing positive externalities to beekeepers.
Establishing and Extending Property Rights
Establishing and extending property rights goes a long way in helping third parties negotiate with individuals or organizations that cause externalities. The establishment of property rights paves the way for bargaining processes that leads to agreements for settling negative externalities.