When the Market gets an F, F for Failure
In economics, an externality refers to the side effect the production or consumption of a good or service has on someone who was not involved in the transaction, and that effect is not captured in the value of said good or service.
Ugh, that sounds cryptic. Let me be clear (clearer?).
There are two parts to the sentence above. First, if you think of it, the word “externality” is closely related to the word “external”, and that means it relates to an outsider, a subject other than the one directly connected to the main activity. Second, the externality occurs when the price that is determined in the market does not reflect this third-party effect. Whatever the effect may be, good or bad, it is borne by others, and not by the parties involved in the action.
So what, what is the problem with the market price not reflecting the true impact of the production and consumption of that good or service, you ask. Why do economists care?
Here is why. Because the price of the good does not reflect its side effects, the market fails to produce the optimum quantity of the good from society’s point of view, or the socially optimum quantity. We call this inability to produce the socially optimum quantity of the good a market failure.
When this happens, and the market produces too much or too little of the good or service, we say it is inefficient. The inefficiency arises because, from society’s perspective, the cost society bears differs from the benefit society enjoys. This mismatch ain’t good, and that is why the market gets an F, F for Failure (to match society’s costs and benefits).
A First Glance at Externalities
Say someone took a shower in the morning and put on a lot of perfume (I do this, don’t judge).
Now imagine you have to ride the elevator with that person (me?).
If you are a person who likes the smell of perfume, or who likes the smell of that particular fragrance, you will enjoy the elevator ride that much more. On the contrary, if you are sensitive to smells or dislike that fragrance, you will not enjoy the elevator ride and will be trying to not breathe until you can get off (I don’t recommend this for long periods of time).
In either case, you were not involved in the action of buying the perfume or putting in on, your wishes or tastes were not considered in the least. And yet you were exposed to that person’s action, which either improved those few seconds or left you with a headache for the rest of the day.
But the person did not think of you or others when putting on the perfume. Nor the improvement to your elevator ride or the discomfort you endured were reflected in the price of the perfume, oh no. The price the person paid for that perfume was the same regardless of its power for good or evil. And that is what makes it an externality.
Had the effect of the activity has on others been incorporated in the transaction, certainly the price would be different!* We call this internalizing the externality, by the way, and that means including the third-party effect in the price of the good or service. Alas, the price is not different, and you remain as unable to foster the use of scents that tickle your fancy as you are unable to deter the use of those that trigger a gag reflex.
*Take this a step further by thinking of the following. How should the price of the perfume be if it brings pleasure to others? Conversely, how should the price of the perfume be if it makes others sick? In which case should it be cheaper so that more people buy it? In which case should it be more expensive so that fewer people buy it?
The Goldilocks Principle Meets Externalities: Too Much or Too Little?
So now you see that what makes it an externality is that the market price of the good or service does not capture the effect of the transaction that is borne by others, may it be good or bad. And, because the price of the good does not reflect its side effects, the market fails to produce the socially optimum quantity.
Going back to our example, if you perceive nicely smelling people as adding to your overall happiness, maybe you think there are too few of them. If, on the contrary, you perceive smells on people, especially bad ones, as taking away from the joy of your days, maybe you think there too many of them. Either way, the ideal number is not what the market is delivering.
In general, in the presence of externalities, the market equilibrium is one of underproduction, where too little is being produced of the good, or overproduction, where too much is being produced of the good. Just like in the Goldilocks story, the porridge was either too hot or too cold.
Types of Externalities
There are two types of externalities, good and bad, or as economists like to call them, positive and negative, respectively. The former occur when the activity causes an external benefit and the latter occur when the activity causes an external cost.
A positive externality occurs when the production or consumption of a good or service generates a benefit for someone else that did produce or consume the good. In this case, the market solution is to produce too little of the good relative to what would be optimal for society. Two examples of positive externalities are vaccination and education.
Click the title above to read more about positive externalities.
A negative externality occurs when the production or consumption of a good or service generates a cost for someone else that did not produce or consume the good. In this case, the market solution is to produce too much of the good relative to what would be optimal for society. An example of a negative externality is air pollution.
Click the title above to read more about negative externalities.