Chapter 11: Problem 14

What is an externality?

Short Answer

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An externality is the unintended consequence, either positive or negative, resulting from an economic activity that is not accounted for in the market price and is experienced by a third party not involved in the transaction. Positive externalities are external benefits to society, such as improved air quality from planting a tree. Negative externalities are external costs to society, such as air pollution caused by a factory, which affects the local environment and health of nearby residents without being accounted for in the market price of the produced goods.

Step by step solution

Define Externality

An 'externality' refers to the unintended consequences, either positive or negative, that result from an economic transaction or activity and are not accounted for in the market price. These consequences are experienced by a third party who is not directly involved in the transaction or decision-making process.

Explanation of Externality

In some cases, these externalities can be beneficial (positive externalities) while in other cases, they can result in adverse effects (negative externalities). Externalities occur because the individuals or firms involved in the transaction do not bear the full cost or receive the full benefit of their actions, leading to a discrepancy between private and social costs/benefits. Positive externalities: These are the external benefits that other people or society as a whole experiences from the actions or decisions of an individual or firm. Negative externalities: These are the external costs that other people or society as a whole has to bear due to the actions or decisions of an individual or firm.

Example of Positive Externality

Suppose an individual decides to plant a fruit tree in their front yard. The individual benefits from the shade and fruits that the tree provides. However, neighbors and passersby also enjoy the beauty of the tree, the shade it provides on hot days, and the improved air quality due to the tree's ability to absorb CO2. This results in a positive externality.

Example of Negative Externality

An example of a negative externality is air pollution caused by a factory. The factory may produce goods in high demand and at low cost, which is beneficial for consumers and the company. However, the pollution generated impacts the local environment and the health of nearby residents, who did not participate in the consumption or production of the goods. This is a cost that neither the factory nor the consumers pay for but directly affects the well-being of others. This negative externality represents a market failure.

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