The Basic Idea
When you’re filling up your car at the gas station, have you ever stopped to think about what goes into deciding the price of that gas? The main components are pretty obvious: the value cost of the gas itself, the price of refinement, distribution, marketing, profits, and applicable taxes. But what about the cost to the environment? Should the price of solar panels, wind turbines, or pollution-related healthcare costs caused by the production process of gas be factored into what you pay?
This is what economists call an externality. An externality is when the production or consumption of a good or service (in this case, gasoline) impacts another party (the environment). In the past, externalities were the responsibility of the government, but this has shifted to the producer and, eventually, to the consumer as seen in the last few decades.
Externalities: A cost or benefit caused by economic activity and experienced by an unrelated third party. For example, the production of plastic water bottles has contributed to increased plastic waste and climate change. In this scenario, climate change is an externality.
Negative externality: When the consequence of an economic activity on an unrelated third party is negative.
Positive externality: When the consequence of an economic activity on an unrelated third party is positive.
Pigouvian Tax: Economist Arthur Pigou proposed a tax on products or services that produce negative externalities. He intended that this price increase would offset the negative impacts of that product or service and enhance social wellbeing.
Social marginal cost: The cost to society of an additional unit of a product or service being produced.
Market failure: A situation in which rational decisions made by an individual do not equal rational decisions for the group as a whole. An example of this is a gas shortage scare where people form long lines at gas stations. They’re acting rationally by stocking up on gasoline, but they hasten the shortage for the rest of their community by doing this.
A dominant figure in economics from 1890 until his passing in 1924, British economist Alfred Marshall was the first to theorize about the presence of externalities in his highly influential book Principles of Economics (1890).1 In his research regarding increasing returns, he noticed a distinction between internal and external economics, which is how the term “externalities” was initially coined.2 As a professor at the University of Cambridge in England, one of his students, Arthur Pigou, became a noteworthy figure in economics for the first half of the 20th century.3
Pigou — Marshall’s successor as departmental chair at Cambridge — introduced the concept of externalities as we understand it today.3 He was responsible for drawing attention to many of Marshall’s theories, and thus became an influential character in the foundation of the Cambridge school of economics.4 In his most famous work, The Economics of Welfare (1920), he refined his predecessor’s theories on externalities, arguing that there needs to be a tax on negative externalities that would offset their effects. This is the origin of the Pigouvian tax. Additionally, he asserted that positive externalities should be compensated with a subsidy. The concept dictated that the tax would increase the price of the good or service such that it would be equal to the social marginal cost.
By the 1970s, the idea of externalities had become integrated and normative, argued University of Wisconsin professor Carl Dahlman.3 Moreover, it has been operationalized in so many different ways that it was now widespread and found in many other sectors of economics, including finance, development, and housing economics, to name a few.5 A quick online search showcases the many ways in which it can be applied, with results ranging from corporate reporting, to wind power, and the COVID-19 pandemic.
One of the most well-known economists of his time, Alfred Marshall made significant contributions to the field of economics. His book, Principles of Economics, was England’s preferred economic textbook for many years. In addition to being a professor at the University of Cambridge, he was the first principal of University College, Bristol — a predecessor to today’s University of Bristol.
One of Marshall’s best students, Pigou is most well-known for disseminating many of Marshall’s economic theories and establishing the intellectual foundation for the Cambridge school of economics. He developed Marshall’s theory of externalities into what we know it to be today.
The list of externalities is nearly endless, given that the term applies to many different actualizations in many different fields. As a result, trying to grasp the consequences of each can be a challenge. Let’s try to break this down by looking at the broad implications of both negative and positive externalities and how they relate to market failure.
Market failure occurs when the quantity of goods or services available is not equal to the demand of these goods and services. Thus, externalities lead to market failure because the benefits or costs of this product or service do not reflect their actual costs.6
Negative externalities do not benefit society because the transaction between two parties harms the unrelated third party. Someone living close to a factory might not agree to allow the factory’s smoke to contaminate their community, causing them to develop asthma or lung cancer.
Similarly, though not initially apparent, positive externalities also represent a failure in the market. There is an opportunity for people to take advantage of a good or service they didn’t pay for. This demonstrates the free rider problem, in which people take more than what is fair, thus creating an imbalance between the quantity of the product and its demand.7
An example of this is the concept of herd immunity: in a community, if enough people get vaccinated, say 75%, there is no more risk of infection. However, the 25% who haven’t gotten vaccinated haven’t “paid their dues” by receiving the vaccine. Although receiving a vaccine is good for one’s immune system, those who remain unvaccinated are free-riding on those who went out of their way to get vaccinated.
With that being said, most externalities have negative consequences. Even though there is some controversy about whether positive externalities are good, the benefits far outweigh the damage done by negative externalities.
Given that the theory of externalities has been around for over a century, there have been a few controversies throughout the years about the topic. The first controversy recognized regards the Pigovian taxes. Pigou’s analysis was widely accepted until 1960, when Nobel Prize-winning economist Ronald Coase presented research that showed that subsidies and taxes on externalities are not necessary when creators of the externality and those who it affects can come together to bargain.8 He claimed that subsidies and taxes on externalities were unrealistic and pointed out that the legal system already governs harmful activities.9 Ultimately, his ideas have not changed economists’ thinking tremendously, but it has influenced legal scholars.9
In addition to arguments about implementing taxes or subsidies, there is the question of how to price such a tax or subsidy. For example, how much money should a government allocate to climate change?
Ecological economists tend to disagree with traditional economists who try to put a price tag on incredibly complex issues, like species extinction or rising sea levels.10 Güney Işıkara, a Clinical Assistant Professor of Liberal Studies at New York University, argues that “ecological breakdown is not a case of market failure, but the failure of the market economy to apprehend, value, and preserve the complex conditions of sustained life for humans and other species on Earth.”10 Other ecological economists argue for and against the concept of externalities in their field, demonstrating the varied perspectives and applications of this term.
In the last few years, bike sharing has soared in popularity. Not only is it affordable, but it’s a great way to get exercise and avoid traffic on a commute, errand, or just for fun. There has been some controversy about bike sharing too, namely around whether the bicycles are properly maintained or if it’s a waste of resources. How does one measure if a program like this has any positive effects on the community? One study, conducted in Beijing in 2018, showed that bike sharing programs create significant positive externalities such as “decreas[ing] traffic, reduc[ing] energy consumption, … and promot[ing] economic growth.”11 Moreover, bike sharing leads to reduced carbon emissions, which benefits everyone.
With the advent of the COVID-19 vaccines and their subsequent approvals by governmental agencies, most people agree that becoming vaccinated has enormous benefits. Not only does it reduce the likelihood that one will contract COVID-19, but it also has positive consumption externalities for the larger society. Even if a few people in a community receive the vaccine, the probability of that community suffering an outbreak is diminished. In the United States, the most vaccinated states are currently in the New England region — Vermont, Connecticut, and Massachusetts.12 Consequently, they have enjoyed the lowest COVID-19 positivity rates per capita in mid-September of 2021, according to the Centers for Disease Control.12
According to the Pigouvian Tax theory, people in these states should receive a stipend to reward these positive externalities. Though the details of executing this initiative might be complicated, rewarding communities as their vaccination rates increase leverages incentive theory, which perhaps may nudge others suffering from vaccine hesitancy to get vaccinated.
Related TDL Articles
How Does Society Influence One’s Behavior?: In line with the discussion of implementing taxes or subsidies for externalities, this article explores the role that society (and government) play in our decision-making processes. Read this article to find out more about how we rarely make choices that are free from influence.
Too Much of a Good Thing: Reciprocity and Corruption: In light of the college admissions scandal of 2019, this article brings up past research on the science of corruption and whether or not negative externalities have any effect on the behavior of government officials. Read this article to learn more about how corruption can see many detrimental effects in our lives today.
- Patrinos, H., & Psacharopoulos, G. (2018, May 21). Economic Benefits of Education Investment, Measurement. Encyclopedia.Com. https://www.encyclopedia.com/social-sciences-and-law/economics-business-and-labor/economics-terms-and-concepts/externalities-economics
- Alfred Marshall. (2018, May 29). Encyclopedia.Com. https://www.encyclopedia.com/people/social-sciences-and-law/economics-biographies/alfred-marshall
- Boundreaux, D. J., & Meiners, R. (2019). Externality: Origins and Classifications. Natural Resources Journal, 59(1), 34.
- The Editors of Encyclopaedia Britannica. (2021, March 3). Arthur Cecil Pigou. Encyclopedia Britannica. https://www.britannica.com/biography/Arthur-Cecil-Pigou
- Medema, S., & Ferey, S. (2015). Externalities in Economic Thought. Œconomia; Association Œconomia. https://journals.openedition.org/oeconomia/366
- The Investopedia Team, & Rathburn, P. (2021, July 21). The Effect of Externalities on Equilibrium and Market Failure. Investopedia. https://www.investopedia.com/ask/answers/051515/how-do-externalities-affect-equilibrium-and-create-market-failure.asp
- The Investopedia Team, & Rasure, E. (2020, December 29). Free Rider Problem? Investopedia. https://www.investopedia.com/terms/f/free_rider_problem.asp
- Arthur Cecil Pigou. (n.d.). The Library of Economics and Liberty. Retrieved September 21, 2021, from https://www.econlib.org/library/Enc/bios/Pigou.html
- Enrico, B. (2007). The Problem of Internalisation of Social Costs and the Ideas of Ronald Coase. University Library of Munich. https://www.academia.edu/52567539/The_Problem_of_Internalisation_of_Social_Costs_and_the_Ideas_of_Ronald_Coase
- Işikara, G. (2020, December 17). Ecological breakdown: What are externalities external to? Developing Economics. https://developingeconomics.org/2020/12/17/ecological-breakdown-what-are-externalities-external-to/
- Qiu, L.-Y., & He, L.-Y. (2018). Bike Sharing and the Economy, the Environment, and Health-Related Externalities. Sustainability, 10(4), 1145. https://doi.org/10.3390/su10041145
- Geske, D. (2021, September 13). These Are The 3 Most Vaccinated States In The US. International Business Times. https://www.ibtimes.com/these-are-3-most-vaccinated-states-us-3294686