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Economy of Externality: Term Definition

Definition of externality

Externality may be defined as a benefit enjoyed or a cost incurred yet it is not factored in the price of the commodity consumed. This means that a consumer may enjoy benefits without having to spend on the acquisition of that benefit or he may incur a cost without having to be a party to the decision of producing the product that necessitated that cost. For instance, a consumer will enjoy the sound of music from a neighbor’s house without paying for it or may breathe filthy air caused by factory emissions without having been party to its production and incur the cost of medication on resulting illness. Externalities may either be positive or negative, commonly referred to as economies and diseconomies respectively. According to Meade and Hjertonsson (1973, p. 15), an externality is “an event that confers an appreciable benefit or inflicts appreciable damage on some person or persons who were not fully consenting parties in reaching the decision or decisions which led directly or indirectly to the event in question”. While negative externalities tend to be harmful to social welfare, positive externalities are very important in improving social welfare because the social benefit derived is always higher than the private/individual benefit, and therefore they are directly influential in the production of public goods. Therefore, the government will always intervene in order to create social efficiency where the social benefit enjoyed is marched against the social cost.

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Negative Externality

According to Markiw (1998, p.202), negative eternality occurs where the society, which is not part of a decision, has to pay more cost for goods consumed than the cost paid by the consumer who was part of the decision. In a free market, a firm incurs a lower cost of producing a good with an externality than the cost paid for the good by society. This leads to shifting of the supply curve to the right as the firms take advantage of incurring a lower marginal cost than socially efficient. The excess supply leads to disequilibrium as social welfare is lost (Markiw, 1998, p. 202). An example of a negative externality is the case where a firm’s drainage of waste ends up in a river. While the firm will only incur costs directly related to the production of the product, the society will have to bear an extra cost of medication in case they drink the contaminated water, or they come into contact with the waste, or worse still the contaminated water causes the aquatic life to die thereby affecting fishermen and others who depend on the aquatic animals. This can be illustrated as follows:

As per the graph, the socially efficient supply is Q* but due to the negative externality, the supply is increased to Q1 as the firms will enjoy the benefit of not paying for the externality. The marginal cost to the society will be rising along S1 while the social marginal benefit will decline as much of the externality is consumed. This generally causes economic inefficiency as the externalities are not reflected in the market prices (Pindyck and Rubinfeld, 2005, p. 642).

Positive Externalities

These are benefits that a consumer derives from the consumption of public goods – goods that are both non-excludable and non-rivalry in consumption whereby the consumption by one individual will not deter another person from consuming it, and there is freedom for everyone to enjoy the benefits of the goods. According to Wessel (1997, p. 112), public goods are a form of externality because they involve high costs of trying to exclude others from consuming them. In a perfectly competitive market where the forces of demand and supply play a critical part in maintaining equilibrium, the society enjoys a higher marginal benefit than the individual making the decision and in such a situation, the demand curve of the individual is lower than that of the society. An example of a positive externality is where a farmer keeps bees. In such a case, the farmer will enjoy harvesting the honey but the social benefit that will be enjoyed by other farmers not directly related to the bee-farming business is enormous.

For instance, the bees will have to collect nectar from, not only the farm of the direct farmer, but also from the neighboring farms, and in the process help to pollinate the farms. Therefore, the neighboring farmers will enjoy the pollination of their farms through the actions of another person without having to be directly involved. This may be demonstrated diagrammatically as:

From the above graph, the price that the consumers are willing to pay is p* for quantity Q* which is lower than social efficiency. With positive externality, the marginal social benefit will shift upwards for the same quantity. However, this will not be an optimal point and therefore measures such as subsidies to the farmer will have to be facilitated in order to push the market to where the social marginal benefit equals the marginal social cost.

Positional Externality

As defined by Bernanke (2003, p. 293), a positional externality is an occurrence “when an increase in one person’s performance reduces the expected reward of another in situations in which reward depends on relative performance”. Simply put, when one person benefits from a certain situation, then there will be another person who will be adversely affected. For example, suppose two people appear for an interview where only one person is supposed to be picked and one person wears expensive suits that make the suit of the other person look inferior, if that person is picked due to perception that he looks impressive, then the other person is bound to suffer. Suppose, however, the other person tends to buy an expensive suit that will match that of the first person, then the second person will have to incur a higher cost due to influence from the position and at the same time the dominance of the first person will have to be weakened as the competition will stiffen.

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Positional externalities have an effect of offsetting the benefits in a relative position where each individual tends to spend or consume more, yet the relative utility derived from such an action does not change. One group of consumers in a given situation is likely to affect the consumption of the other consumers. For instance, when the wealthy persons purchase expensive cars, the middle-income earners are also likely to shift gear and buy much better cars than they have; this will even force the low-income earners to view cars as a necessity and therefore they will have to adjust their position in a bid to acquire a car, even if it means to forego some of the other basic commodities.

Government intervention in externalities

Since externalities have a social implication, then the government should step in to control and regulate them in order to create efficiency in the social welfare (Cornes and Sandler, 1996, p. 6). Generally, the government will aim at creating sanity in the market such that the social marginal benefit equates to the social marginal cost. In most cases, the government will intervene to protect the welfare of the people, especially where there are negative externalities such as environmental pollution. This is normally done through control policies and measures such as taxes, standards, subsidies, and other Acts of government.

In the cases of a positive externality, government intervention does not interfere with the MC since such intervention seeks to increase the supply of the commodity, thus it affects only the demand of the commodity, which is equivalent to social marginal benefit. However, government regulation of the negative externality aims at reducing the supply of the commodity and therefore shifts the MC upwards towards the social efficiency point as shown in the above graph, Fig: 3 above. The social marginal cost will be comprised of individual marginal cost plus the cost of reducing the externality.


The government will use tax measures to regulate externalities. According to Mankiw and Taylor (2006, p. 198), the government’s decision to tax activities that involve negative externalities like pollution is very efficient considering that, such externalities can be reduced effectively and at a lower cost to the society. The use of tax has an absolute effect as it provides an economic incentive that will force the firm to produce the negative externality to reduce such externality. For instance, the government may impose a certain percentage of tax on a certain level of pollution thus forcing the firms to cut down pollution in order to avoid incurring the tax. It becomes so effective that those firms who can not cope with the tax levied will have to shut doors thereby reducing negative externality to zero. From the above fig:3 above, MC, where there is no taxation, will be equivalent to individual MC, but when taxes are imposed, the firms cut production, shifting the MC curve upwards to the social optimum point. The most important aspect of taxes is that, apart from being a source of revenue to the government, it also facilitates the correction of the social optimality by efficiently allocating resources. This means that the social marginal cost is reduced to a point where it equates to the social marginal benefit. The effect of taxes on market efficiency will be influenced by the price of tax set by the government. Since the demand curve of externality is perfectly elastic, a firm will have no limitation on the level of externality as long as it can pay the tax (Mankiw and Taylor, 2006, p. 198).


According to Markiw (1998, p.212), permits are contracts or agreements made whereby two or more firms trade off the right to produce an externality. For instance, where the government has issued a policy on the level of pollution that each firm should reduce, one firm may opt to transfer its right of reducing pollution to another firm at a fee. This will make one firm reduce pollution by a certain level while the other firm raises pollution at an equivalent level plus compensation to the former firm. These permits form a good policy that goes well with market forces and aids market efficiency considerably. The permits also give a balancing effect since those firms that can reduce externalities at a lower cost have the option of selling their permits to those firms that can only reduce negative externalities at a high cost (Taylor and Weerapana, 2007). Permits tend to favor situations where taxation may be hard to enforce. In an externality market, permits may play a key role in efficiency. Since the quantity of negative externality will be set by the number of permits available, the supply curve is perfectly inelastic. The demand of externality will depend on the quantity the government sets thus; the firms will not have the right to exploit the welfare of the state.


Organization for Economic Co-operation and Development (1996, p. 139) defines subsidies as “public payments which directly benefit the private production or consumption of goods and services”, especially where the production will have a positive externality to the society. The government may intervene to boost social efficiency, especially where there are positive externalities by providing subsidies. In addition, the production of positive externalities leads to the production of more public goods thus the need for the government to intervene. According to Harford (2005, p. 104), positive externalities are among the things that make life worth living although they are in most cases under-provided. Where a firm or individual produces an externality that positively affects society, the government can step in to offer subsidies in order to motivate the producer to produce more of the positive externality. Take, for example, a farmer keeping bees whose effect is pollinating other farmers’ farms, the government subsidizes bee keeping by providing low-cost hives or other farming equipment. Subsidies can also be applied to negative externalities in form of tax credits where the government subsidizes the equipment or processes used to reduce negative externalities. For example, in pollution, the government may subsidize the installation of pollution controls or even finance such installations outright.


The government may set standards on the level of externality permitted, beyond which the firm that violates the standards is fined or penalized. McKenzie and Lee (2006, p. 199) argue that the government has the capacity to impose standards on the negative externalities that they may produce, and the violators made to cover for the cleanup costs, be fined, or even risk losing their operating license.

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Contracts are almost related to the permits in that; they both involve setting a quota on the level of externality production permitted. According to Markiw (1998, p. 210), contracts involve instituting a legal remedy by the firm producing negative externality to the affected/injured parties, which may include payment of damages. This means that there will be a regulatory framework that will seek to balance the net benefits of pollution to the firm with the social costs incurred through the production of the externality. Due to the extreme cases of consumable production breakdown and excess externality production, negotiations always take place through government arbitration. In some cases, private agreements are an option but where they fail, the government comes in to provide collective action (Mankiw, 1998, p. 210). Considering that setting extreme quotas on reduction of externality production may force the firm to close down and in the process affecting the supply of essential goods, contracts are drawn where the firm is enforced to afford a legal remedy in form of compensation for any injury caused through its production. The implication of the contracts will be that most firms will tend to curtail their production of negative externality as much as possible in order to avoid incurring the legal remedy of damages to the society. This will in turn promote social efficiency by marching social marginal benefit to social marginal cost.

Acts of government

Through its mandate to ensure the welfare of the persons, the government enacts various Acts to deal with externalities. Most of the externalities have an effect on the environment which may include water pollution, air pollution, and noise pollution. It is the obligation of the government to ensure each of these environmental nuisances is reduced to the most minimum level possible. The government has taken stringent measures by enacting environmental laws that control and aim at ensuring a clean environment. Some of the Acts are Clean Water Act, Clean Air Act, among others (Goklany, 2006, p. 233).

Clean Water Act

According to Goklany (2006, p. 233), Clean Water Act was passed into law in 1972 to control the provision of quality and clean water through stringent environmental regulations. Even before the enactment of the laws, the government used other mechanisms to ensure clean and quality drinking water. The Clean Water Act’s mandate is to ensure all water, whether in the homesteads or in the streams is clean at all times in order to maintain aquatic life as well as boosting public health. The Act controls the use of pesticides and factory waste emissions to ensure they are not directed to the streams. This Act is reinforced by the enactment of the Safe Drinking Water Act that aims at ensuring all water termed drinking water is safe for human consumption. The regulations under these two acts emphasize stringent measures being taken against the violators of the regulations. These Acts work well when combined with other government policies like the provision of subsidies for environmental conservation – which aims at protecting the wetlands. The motivating factor on the application of these Acts is the fact that the government has the mandate to provide, not only basic public health and poverty reduction measures, but also safe water and sanitation (Goklany, 2006, p. 234).

Clean Air Act

This Act was passed in 1970 to ensure the provision of clean air to all the members of the society (Goklany, 2006, p. 233). The government’s mandate of environmental protection ensures that the level of pollution from factories and other institutions is put to the minimum. The Act sets the minimum standards that potential polluters should meet. The Act tends to accelerate the cleanup of the environment in order to reduce the impact of pollution on public health. The Act is designed to give emission indicators and keep track of the level of emissions as well as their impact on public health. The emission indicators help to gauge the effect of emissions on the economic performance as well as trying to resolve the issue of air quality.

The Act deals with the quality of air, not only from factory emissions but even emissions from homesteads. Generally, the Act deals with the quality of both indoor and outdoor air. According to Goklany (2006, p. 233), “indoor air pollutions are an equally important indicator of the impact of air pollution”.

Noise control

Noise pollution especially in urban areas has always been a menace and an influence in public health disturbance. According to Langran and Schnitzer (2007, p. 173), noise pollution especially persistent noise can lead to heart diseases, high blood pressure as well as ear injury. The Noise Control Act of 1972 was passed in order to deal with the impact of noise pollution on public welfare. The main agenda is to set standards for noise control mostly dealing with industries like airlines, railways, and automobile and manufacturing industries. In addition, the standards are aimed at enforcing the major noise polluters to abide by the regulations whose main objective is to take care of the health, safety, and welfare of the people. The Noise Control Act enhances social efficiency by regulating the use of modern technology that is less noisy as well as monitoring the adherence to regulations.

In addition to these measures taken by the government, there are extreme cases where the only viable option of government regulation is prohibition. According to Leach (2004, p. 110), some cases may adversely affect the community, the prohibition of which will provide a win-win solution. For example, hunting in the game reserve may cause an externality that tends to endanger wildlife, but banning it will benefit both the society and the hunter himself.

The role that government plays in protecting its citizens against the adversaries of externalities is crucial as it boosts the welfare of the consumers. If firms and individuals were given unlimited control of the environment, then there can never be sanity as there will always be competition to make as much profits/benefits as possible with little concern on the effects of such competition on social welfare. In addition, where firms or individuals will be allowed to produce externality without paying for them, then they will tend to increase supply, as the cost of production will be less than it is supposed to be where there is government intervention. On the other hand, there will be less production of positive externality as there will be less incentive to produce the public goods by private firms/individuals. Therefore, the government plays a key role, not only in controlling externalities but also in boosting the living conditions of the society.

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