Externality

An externality is a side effect of production or consumption that falls on someone outside the transaction and is not reflected in its price. When a power station emits smoke, nearby residents bear health costs that neither the station nor its customers pay for. When a homeowner restores a run-down facade, neighbours enjoy a nicer street without contributing. The first is a negative externality, the second a positive one.

Externalities are the most widely discussed cause of market failure. Because buyers and sellers weigh only their own costs and benefits, markets tend to overproduce activities with harmful spillovers and underproduce those with beneficial ones. The concept underpins environmental policy, congestion charging, vaccine subsidies and much of the case for public goods provision, and it is closely linked to the tragedy of the commons.

Picture a neighbour who throws a loud party every Friday. The host enjoys it and the guests enjoy it, but the people next door lose sleep, and nobody asks them or pays them for it. If the host had to compensate the neighbours, the parties might end earlier or happen less often.

That missing compensation is the heart of an externality. The people making the decision do not feel the whole effect of what they do, so they do more of it (or, for good side effects, less of it) than they would if the full effect landed on them.

Economists separate the cost borne by the decision-maker from the cost to society as a whole. For a negative production externality, the relationship is:

• $\text{MSC}$ is the marginal social cost, the full cost to everyone of producing one more unit.
• $\text{MPC}$ is the marginal private cost paid by the producer, such as fuel, wages and materials.
• $\text{MEC}$ is the marginal external cost imposed on third parties, such as health damage or lost crops.

Suppose a factory's private cost of producing one more tonne of cement is $80 and the pollution from that tonne causes $20 of harm to local residents. The social cost is $80 + $20 = $100 per tonne. If the market price is $90, the factory will keep producing because it earns $10 above its own cost, even though each extra tonne destroys $10 of value for society overall. The efficient output is the level at which price equals the $100 social cost, not the $80 private marginal cost. Positive externalities work the other way round: the marginal social benefit exceeds the private benefit, so too little is produced.

• Negative production externalities. Industrial pollution, greenhouse gas emissions and runoff from farms are standard examples.
• Negative consumption externalities. Road congestion, second-hand smoke and antibiotic overuse, which breeds resistant bacteria, all impose costs on others.
• Positive production externalities. Research and development creates knowledge that other firms can build on, and beekeepers' bees pollinate nearby orchards.
• Positive consumption externalities. Vaccination protects people who are not vaccinated, and education is widely argued to raise civic participation and productivity beyond the individual's own gain.
• Network and financial externalities. A network effect means each new user raises the value of a service for others, while a bank's risk-taking can create systemic risk that spills onto the wider financial system.

The British economist Arthur Pigou proposed in 1920 that the state tax activities with harmful spillovers by the amount of the external damage. A Pigouvian tax, of which a carbon tax is the best-known modern example, raises the producer's private cost until it matches the social cost. Beneficial spillovers can be encouraged with a subsidy of the same logic.

Alternatives include direct regulation (emissions limits, building codes), cap-and-trade schemes in which a regulator sets a total and lets firms trade permits, as in the EU Emissions Trading System since 2005, and the private bargaining route set out in the Coase theorem, which holds that if property rights are clear and negotiation is cheap, the affected parties can reach an efficient deal themselves. Investors have also begun to account for some externalities through ESG investing and climate disclosure frameworks such as those of the TCFD.

Measuring external costs is hard. Estimates of the social cost of carbon vary widely depending on the discount rate chosen and assumptions about future damage, and official US estimates have been revised several times by successive administrations. Critics of Pigouvian taxes note that regulators rarely know the precise marginal damage, that taxes can fall heavily on poorer households (a question of tax incidence), and that lobbying can shape the rate. Supporters reply that an imperfect price is usually better than none, and that revenues can be returned to households. Coasean critics, for their part, argue that many spillovers are better handled by clarifying rights and allowing courts or contracts to settle them, although Coase himself stressed that high transaction costs often make that impractical when many people are affected.

• IMF Finance & Development: Externalities, Prices Do Not Capture All Costs