Externalities in the economy are Definition of the concept, positive and negative effects, examples

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:55

Externalities in the economy are the impact of one person's activities on the well-being of another. This is an interesting section that not only studies new formats of relationships between enterprises and consumers, but also regulates problems arising from the lack of public goods and resources.

How it all started

Sometimes the market stops working as expected, and so-called dips occur in it. Often the market model cannot cope on its own with this kind of phenomena. And then the state has to intervene to restore the balance.

The fact is that people use the same resources: the world and the earth cannot be divided into sections of private space. The actions of one person can harm another person without the presence of any malicious intent. In the language of economists, a positive factor in the form of consumption or production of one can lead to a negative impact on consumption or production.other.

These are the impacts that cause market failures. They are called external effects, or externalities.

Definition of externalities and their types

There are many formulations of external effects. The shortest and clearest of them is as follows: externalities in the economy are the gains or losses from market transactions that were not taken into account and, as a result, were not reflected in the price. Most often, such things are observed in the consumption or production of goods.

Goods are everything that benefits and pleases a person. If we mean economic benefits, then these are desirable, but limited in quantity goods and services.

Positive and negative externalities in the economy differ in the nature of the impact on the subject: negative effects lead to a decrease in the utility of a consumer or the products of a firm. Positive, on the contrary, increase utility.

Classification of types of external effects in the economy is determined by several criteria, one of them - by the type of influence on the subject:

• technological (as a result of economic activity not subject to market processes);
• cash (expressed as changes in the cost of factors of production).

Effects by level of influence on the subject:

• marginal;
• intra-margin.

By the method of transformation or elimination:

• externalities that only the state can handle;
• effects that are neutralized by negotiations betweenexternality recipient and producer.

Four Directions for External Effects

1. Production - production

An example of a negative effect: a large chemical plant releases waste into the river. A downstream bottled beer factory has filed a lawsuit over damages to brewing equipment processing technology.

Positive effect - mutual benefit from the neighboring bee apiary and fruit farm (direct relationship between the amount of honey harvested and the number of fruit trees).

2. Production - consumer

Negative example: harmful emissions into the atmosphere from the pipes of a local factory reduce the quality of life of urban residents. And with the same alignment of forces, a positive effect: the repair of railway sidings and the underpass from the station to the factory passage brought benefits to residents of neighboring areas in the form of convenient movement and cleanliness in the city.

3. Consumer - production

Negative Impact: Numerous family picnics cause huge damage to forestry due to forest fires. Positive effect: the emergence of volunteer organizations for the preservation of cleanliness in the external environment has led to systematic cleaning and cleanliness in city parks.

4. Consumer - consumer

Negative effect: classic showdown between neighbors because of loud music from one of them in the late evenings. The quality of lifeother "listeners" is sharply reduced. Positive impact: every spring, a flower lover sets up a flower garden under the windows of a multi-storey building. For neighbors - continuous positive emotions of visual origin.

Positive externalities in the economy

Let's deal with the "increase in utility", which is expressed in growth and is regarded as an external benefit of some kind of activity.

A large enterprise that built access roads and high-quality highways within the city for its production needs has benefited the inhabitants of this city: they also use these roads.

Another example of positive externalities in the economy is the fairly common situation with the restoration of historic buildings in the city. From the point of view of most citizens, this is the enjoyment of beauty and architectural harmony, which is an absolutely positive factor. From the point of view of the owners of such old buildings, the restoration process will bring only serious costs and no benefits. In such situations, the city government often takes the initiative, providing tax breaks or other support to the owners of dilapidated buildings, or, conversely, placing obstacles to their demolition.

Negative externalities in the economy

Unfortunately, negative impact is more common in real life. If the activities of one entity adversely affect the activitiesanother, it is an externality in the economy with a negative effect. Numerous examples are cases of pollution of the external environment by industrial enterprises - from dispersed particles in the air to polluted water in rivers and oceans.

A huge number of court hearings are being held around the world about the increase in the incidence of people due to declining water quality, dirty air or chemical contamination of the soil. Cleaning equipment, as well as all other activities to minimize pollution of any kind, are expensive. These are serious costs for manufacturers.

An example of negative externalities in the economy is the case of a paper mill that uses clean water from a nearby river for its production technology. The factory does not buy this water and does not pay anything for it. But it deprives other consumers of the opportunity to use river water - fishermen and bathers. Clean water has become a limited resource. The factory does not take into account external costs in any way, it operates in a Pareto-inefficient format.

Cose theorem: the problem can be solved

Ronald Coase - Nobel laureate in economics, author of the famous theorem under his own name.

The meaning of the theorem is as follows: private and social costs are always equal, regardless of the distribution of property rights between economic entities. According to Coase's research and the main theses of his theory, the problem of externalities can be solved. Solution method -expansion or formation of additional property rights. We are talking about the privatization of resources and the exchange of ownership of these resources. Then external effects will turn into internal ones. And internal conflicts are easily resolved through negotiations.

It is easiest to understand the theorem on real examples, of which there are many today.

Managing spillovers: corrective taxes and subsidies

The Coase theorem reveals two ways to regulate positive and negative externalities in the economy:

1. Corrective taxes and subsidies.
2. Privatization of resources.

A corrective tax is a tax on the output of goods with a negative externality to raise marginal private cost to marginal social cost.

A corrective subsidy is issued in cases of positive externality. Its goal is also the maximum approximation of the marginal private benefits to the marginal public.

Taxes and subsidies both aim to reallocate resources to make them more efficient.

Privatization of resources

This is the second approach from Ronald Coase, which is to privatize resources in the form of an exchange of ownership rights to them. In this case, external effects will change status and be modified into internal ones, which are much easier to solve.

There is another way to solve the problem of externalities: to persuade the one who is the source of the externality to cover all the costs. If this succeeds, the producer of external costs will begin to optimize the balance of benefits andcosts, and this situation is called Pareto efficiency.

If payment for the received positive effect is impossible or inappropriate, then this good turns into a public good - the property right changes. It becomes a purely public good with two properties:

"Non-selectivity": the consumption of a good by one subject does not exclude its consumption by other subjects. An example is the traffic police officer, whose services are used by drivers of all cars passing by

"Non-excludability": if people refuse to pay, they cannot be prevented from enjoying a public good. An example is a state defense system that has two of the above properties at once

Life examples

• Emissions from car engines are externalities to the economy with a negative impact in the form of poisoned air that many millions of people breathe. Government intervention is to try to reduce the number of cars through a tax on gasoline and strict regulations on car emissions.
• An excellent example of a positive externality is the development of new technologies, and with them the emergence of a whole layer of new knowledge that society uses. Nobody pays for this knowledge. Authors and inventors of new technologies cannot reap the benefits that the whole society receives. Research resources are declining. The state solves this problem in the form of paying patents to scientists, thus redistributingownership of resources.

Internalize Externalities: Marry the Neighbor

We have already mentioned the transformation of external effects into internal ones. This process is called internalization. And the most popular way is to combine the subjects associated with the external effect into a combined common face.

For example, you bored your neighbor to death with her loud music with low frequencies in the late evenings. But if you marry this neighbor and unite as one person, the reduction in the utility of this effect will be perceived by the single family as a general reduction in the utility of the effect.

And if the aforementioned chemical production and the brewing company unite under the umbrella of a common owner, the water pollution externality disappears, because the costs of reducing beer production will now be covered by the same company. So water pollution will now be minimized as much as possible.

Conclusion

Externality in the economy, or externality, is the impact of one person's activities on the well-being of another. Externalities and institutional economics (a new and extremely promising branch of economics) are an excellent tandem for studying and implementing the most advanced social and economic technologies to improve the well-being of citizens.

Sound, accurate and evidence-based economic policies for public goods and resource ownership are the future model of relationshipsstates, owners and citizens. The influence of external effects on the economy increases due to the growing scarcity of resources. So the balance and respect for the interests of all parties is a real and optimal possibility for the existence of a modern social society.