This blog post examines the impact of externalities on resource allocation and government solutions. We also explore policies to reduce externalities that cause market failure.
In daily life, one person’s economic activity inevitably affects another’s, and these impacts are usually reflected in market prices. However, situations arise where an individual’s economic activity unintentionally benefits or harms others, yet this is not reflected in prices. For example, drivers emit exhaust gases onto streets, and factories producing goods may cause odors or noise. These activities affect third parties, even if unintentional, yet no compensation is received or paid for this impact. This is termed an ‘external effect’ in economics. The term “external effect” originates from the idea that the benefits or harms inflicted on third parties exist “outside the market” because they possess characteristics that cannot be bought or sold in the market. Since they exist outside the market, no price is formed for them, and they are naturally not reflected in market prices.
While external effects can be negative, as in the examples mentioned earlier, they can also be positive. For instance, if someone cleans the street in front of their house daily, neighbors can enjoy walking along a clean, pleasant street. If a new flower shop displays fragrant flowers every day, people passing by can enjoy the floral scent without paying anything. Such externalities that provide unintended benefits to others are called ‘positive externalities’. Conversely, external effects that cause unintended harm to others are called ‘negative externalities’.
Positive and negative externalities disrupt the functioning of market principles. This is because the impact one economic agent has on another is not adequately compensated through the market or prices. For example, a private car driver emits exhaust fumes but does not compensate pedestrians near the road for the harm caused. Similarly, factory operators generating noise or foul odors do not compensate nearby residents for the harm. Likewise, neighbors do not compensate the florist whose flower scents improve people’s moods. In such situations, negative externalities are produced in excess of socially desirable levels because they incur no cost, while positive externalities are produced below socially desirable levels because they receive no reward.
Government intervention is necessary to resolve this inefficient allocation of resources. When negative externalities occur, the government employs regulatory methods such as prohibition, isolation, setting standards, or imposing taxes. For example, it may limit the amount of pollutants a company can emit or impose an environmental pollution tax. In this case, the company will strive to reduce the amount of pollution emitted because its production costs increase. Conversely, when positive externalities occur, the government encourages such activities through subsidies or tax incentives. For instance, the government may provide subsidies or tax benefits for activities that bring significant societal benefits, such as afforestation projects. These policies play a crucial role in promoting the expansion of positive externalities.
Furthermore, externalities are a vital concept for deeply understanding how an individual’s economic activities impact the entire community. For society to remain healthy, individual economic actors must be able to consider how their activities impact others and the community. Therefore, effectively managing externalities has become a critical task for public policy, ensuring not only the efficient allocation of resources but also the sustainability of the community. Appropriate government intervention and regulation are essential to enhance overall societal welfare, which can ultimately benefit all economic actors in the long term.
