Externalities

Thomas Sim PEA2066

Q.
What do you understand by 'externalities'?

A.

In economics, an externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit.[1]
For example, manufacturing activities that cause air pollution impose health and clean-up costs on the whole society, whereas the neighbors of an individual who chooses to fire-proof his home may benefit from a reduced risk of a fire spreading to their own houses. 

If external costs exist, such as pollution, the producer may choose to produce more of the product than would be produced if the producer were required to pay all associated environmental costs. If there are external benefits, such as in public safety, less of the good may be produced than would be the case if the producer were to receive payment for the external benefits to others. 

For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed monetary value of benefits and costs to all parties involved.[2][3] Thus, unregulatedmarkets in goods or services with significant externalities generate prices that do not reflect the full social cost or benefit of their transactions; such markets are therefore inefficient.

Implications

Voluntary exchange is considered mutually beneficial to both parties involved, because buyers or sellers would not trade if either thought it detrimental to themselves. However, a transaction can cause additional effects on third parties. From the perspective of those affected, these effects may be negative (pollution from a factory), or positive (honey bees kept for honey that also pollinate neighboring crops). Neoclassical welfare economics asserts that, under plausible conditions, the existence of externalities will result in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, whereas those who enjoy external benefits do so at no cost.
A voluntary exchange may reduce societal welfare if external costs exist. The person who is affected by the negative externalities in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality may even be seen as a trespass on their lungs, violating their property rights. Thus, an external cost may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly defined property rights, as with, for example, pollution of bodies of water that may belong to no one (either figuratively, in the case of publicly owned, or literally, in some countries and/or legal traditions).
On the other hand, a positive externality would increase the utility of third parties at no cost to them. Since collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will be produced than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase societal productivity and well-being; but controversial, as these benefits are generally internalized, e.g., in the form of higher wages), public health initiatives (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement. Positive externalities are often associated with the free rider problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.

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