What are externalities?

Externalities are the unintended positive or negative consequences of an economic activity that are experienced by people who are not part of that activity. These consequences can affect third parties, society as a whole, or even the individual actors who engage in the economic activity themselves.

There are two main types of externalities: positive externalities and negative externalities. Positive externalities bring benefits to third parties not involved in the economic transaction or decision. Examples include education (a more educated population can lead to better job opportunities for everyone and lower crime rates) and vaccinations (when a sufficient proportion of the population is vaccinated against a certain disease, fewer people get infected, providing indirect protection to those who are not vaccinated). Negative externalities impose costs on third parties not involved in the economic transaction or decision. Examples include air and water pollution (when companies produce goods that create pollution, individuals and the environment suffer as a result), and noise pollution (when a factory or construction site creates a lot of noise, nearby residents and other businesses suffer from the disturbance).

When externalities are present in an economic activity, markets can become inefficient and fail to achieve a socially optimal allocation of resources. This is because the private actors engaging in the economic activity often do not properly account for the full costs (in the case of negative externalities) or benefits (in the case of positive externalities) of their actions. This can result in overproduction or underproduction of goods and services relative to the socially optimal level.

Governments and policymakers can intervene to correct the market inefficiencies caused by externalities. Some common solutions include: 1. Pigouvian taxes or subsidies - Governments can impose taxes on activities that produce negative externalities or provide subsidies for those that produce positive externalities, in an effort to internalize the costs or benefits and align private incentives with social objectives. 2. Regulation - Governments can establish regulations or standards that limit the degree of negative externalities (e.g. pollution limits for companies) or encourage positive externalities (e.g. making vaccination mandatory). 3. Property rights - Clearly defined property rights can help reduce externalities by allowing affected parties to negotiate solutions and transfer resources to the party who can best manage the externality (as described in the Coase Theorem). 4. Public goods provision - In the case of certain positive externalities, such as public goods with non-excludable and non-rivalrous benefits, governments can produce and provide these goods directly to ensure that they are available to all members of society.