Externalities in Economics. Overview and Explanation

Table of Contents

An externality is when you do something that affects the well-being or the good of another person or a company but you’re neither harmed nor rewarded for what you did to that person. So the externalities can be positive and they can be negative. 

Negative Externalities

A negative externality is when you’ve harmed someone, you’ve done something to somehow impose a cost on someone or some company and you haven’t reimbursed that person you haven’t paid them any money or done anything to compensate for what you did.

So let’s say that it’s a company that we’re talking about that manufactures chemicals and so when they produce their chemicals there’s some sludge that’s leftover and they just dump it in a nearby river. So let’s say that there’s a house near the river and the kids that from that home they play in the river and they get sick. That company has imposed costs on this family the children are getting sick. What if the company hasn’t done anything to reimburse that family. They’re basically creating a negative externality. There they’re harming someone by what they’re doing. So as they produce the chemicals they’re creating this sludge that is getting in the river and it’s harming these people but the people aren’t being made whole.

So another thing would be let’s say that you had a neighbor, let’s say you live in an apartment complex and your neighbor on the other side of the wall really loves to play Britney Spears music at 3 o’clock in the morning. So they’re playing all these Britney Spears songs “Hit me baby one more time” all the stuff at 3:00 a.m. in the morning and you are having to listen to this. So you say “Hey I’ve got an exam tomorrow and I can’t study because this person is constantly listening to this music.” So they’re creating costs they’re doing harm to you but they haven’t reimbursed you. Now if they had said ‘You look I just really love Britney Spears, I hear Britney Spears of 3 a.m.” and you said “Ok you know what I’ll deal with this but I need you to give me an extra 50 bucks a month toward my rent.” and then you work out an agreement that’s different but we’re assuming here they haven’t done anything to reimburse you. They’re not paying you, they’re just doing something that harms you and you’re not getting any benefit of that.

Positive Externalities

Now a positive externality is where you are doing something that doesn’t harm someone it actually benefits that other person, you’re doing something good that is just as a side test. It’s actually helping some other person or people but those people aren’t turning around and compensating you for it. So you’re doing something good, you’re helping yourself but it has a side benefit. If it helps other people but those people aren’t doing anything for you and so for example when you get a flu shot you get a flu shot or Corona vaccine and so you’re doing something that helps yourself, you’re trying to avoid getting corona or the flu and so forth. So I’ll just get this flu shot but you’re actually helping other people as well because if you get the flu shot then other people are less likely to get the flu as well so they’re benefiting. The people who work around you and all these other people are benefiting from what you’ve done but they’re not compensating you they’re not saying ‘Hey you know what I’m really glad you went and got the flu shot here’s a dollar or something like that.”

So what happens is because you’re not receiving the full social benefit you’re just getting your own private benefit basically things where there’s a positive externality that good is going to be undersupplied. If you were actually paid if people really like what you did and then you reap the full social benefit for what you did you might be more likely to get a flu shot. and just if you live in a neighborhood and there are other homes that are nearby and you do a good job maintaining your lawn but your neighbor don’t really spend a lot of time making their house look pretty. Now if your neighbor is trying to sell their house they have a for sale sign up they might appreciate it if you went out and really did a great job maintaining your home they would really just love that because then when people come to see their house which is for sale that would increase the value of their home. If the neighboring proper like yours look really really nice then that would help them sell their home because the neighborhood would look great but you don’t have an incentive to do that. Why? Because you’re only considering your own private benefit, you don’t benefit if their home goes up in value. Basically, if you do something nice and for your home then that would help their home’s value but they wouldn’t turn around and compensate you necessarily that’s a positive externality. For that reason, these types of goods that have a positive externality would be undersupplied in situations where you have a negative externality like pollution or something like that it would be oversupplied relative to what is socially efficient or optimal.

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