Editing Externality (section)

{{Short description|In economics, an imposed cost or benefit}}
[[File:Diesel-smoke.jpg|thumb|[[Air pollution]] from [[motor vehicle]]s is an example of a negative externality. The [[Air pollution#Health effects|costs of the air pollution for the rest of society]] is not compensated for by either the producers or users of motorized transport.]]
{{Green economics sidebar}}

In [[economics]], an '''externality''' is an [[Indirect costs|indirect cost]] ('''external cost''') or benefit ('''external benefit''') to an uninvolved third party that arises as an effect of another party's (or parties') activity. Externalities can be considered as unpriced components that are involved in either consumer or producer consumption. [[Air pollution]] from [[motor vehicle]]s is one example. The [[Air pollution#Health effects|cost of air pollution to society]] is not paid by either the producers or users of motorized transport. Water pollution from mills and factories are another example.  All (water) consumers are made worse off by pollution but are not compensated by the market for this damage.

The concept of externality was first developed by [[Alfred Marshall]] in the 1890s<ref name="Boudreaux">{{Cite journal |last1=Boudreaux |first1=Donald J. |last2=Meiners |first2=Roger |date=2019 |title=Externality: Origins and Classifications |url=https://www.jstor.org/stable/26617802 |journal=Natural Resources Journal |volume=59 |issue=1 |pages=1–34 |jstor=26617802 |issn=0028-0739}}</ref> and achieved broader attention in the works of  economist [[Arthur Cecil Pigou|Arthur Pigou]] in the 1920s.<ref name="Pigou-2017">{{Citation|last=Pigou|first=Arthur Cecil|title=Welfare and Economic Welfare|date=2017-10-24|url=http://dx.doi.org/10.4324/9781351304368-1|work=The Economics of Welfare|pages=3–22|publisher=Routledge|doi=10.4324/9781351304368-1|isbn=978-1-351-30436-8|access-date=2020-11-03|url-access=subscription}}</ref> The prototypical example of a negative externality is environmental pollution.  Pigou argued that a tax, equal to the marginal damage or marginal external cost, (later called a "[[Pigovian tax|Pigouvian tax]]") on negative externalities could be used to reduce their incidence to an efficient level.<ref name="Pigou-2017" />  Subsequent thinkers have debated whether it is preferable to tax or to regulate negative externalities,<ref>{{Citation|last1=Kolstad|first1=Charles D.|title=Ex Post Liability for Harm vs. Ex Ante Safety Regulation: Substitutes or Complements?|date=2018-01-12|url=http://dx.doi.org/10.4324/9781315197296-16|work=The Theory and Practice of Command and Control in Environmental Policy|pages=331–344|publisher=Routledge|isbn=978-1-315-19729-6|access-date=2020-11-03|last2=Ulen|first2=Thomas S.|last3=Johnson|first3=Gary V.|doi=10.4324/9781315197296-16|url-access=subscription}}</ref>  the optimally efficient level of the Pigouvian taxation,<ref>{{Cite journal |last=Kaplow |first=Louis |title=Optimal Control of Externalities in the Presence of Income Taxation |date=May 2012 |journal=International Economic Review |volume=53 |issue=2 |pages=487–509 |doi=10.1111/j.1468-2354.2012.00689.x|s2cid=33103243|issn=0020-6598|url=http://eprints.lse.ac.uk/58172/1/__lse.ac.uk_storage_LIBRARY_Secondary_libfile_shared_repository_Content_STICERD_PEP%20discussion%20papers_pep02.pdf }}</ref> and what factors cause or exacerbate negative externalities, such as providing investors in corporations with limited liability for harms committed by the corporation.<ref>{{Cite journal |last=Sim |first=Michael |date=2018 |title=Limited Liability and the Known Unknown |url=https://www.ssrn.com/abstract=3121519 |journal=Duke Law Journal|volume=68|pages=275–332 |doi=10.2139/ssrn.3121519 |s2cid=44186028 |issn=1556-5068 |via=SSRN|url-access=subscription }}</ref><ref>{{Cite journal |last1=Hansmann |first1=Henry |last2=Kraakman |first2=Reinier |date=May 1991 |title=Toward Unlimited Shareholder Liability for Corporate Torts |journal=The Yale Law Journal |volume=100 |issue=7 |pages=1879 |doi=10.2307/796812 |jstor=796812 |issn=0044-0094|url=https://digitalcommons.law.yale.edu/fss_papers/5035 }}</ref><ref>{{cite journal |last=Buchanan |first=James |author2=Wm. Craig Stubblebine |title=Externality |journal=Economica |date=November 1962 |volume=29 |issue=116 |pages=371–84 |doi=10.2307/2551386 |jstor=2551386}}</ref>

Externalities often occur when the production or consumption of a product or service's private price [[Economic equilibrium|equilibrium]] cannot reflect the true costs or benefits of that product or service for society as a whole.<ref name="Mankiw">{{Cite book |title=Principios de Economía (Principles of Economics) |last=Mankiw|first=Nicholas |publisher=Cengage Learning |year=1998 |isbn=978-607-481-829-1 |location=Santa Fe |pages=198–199}}</ref><ref>{{Cite web | url=https://www.investopedia.com/ask/answers/051515/how-do-externalities-affect-equilibrium-and-create-market-failure.asp | title=How do externalities affect equilibrium and create market failure? |website=investopedia}}</ref> This causes the externality competitive equilibrium to not adhere to the condition of [[Pareto efficiency|Pareto optimality]]. Thus, since resources can be better allocated, externalities are an example of [[market failure]].<ref>{{cite book |last1=Gruber |first1=Jonathan |title=Public Finance and Public Policy |publisher=Worth Publishers |isbn=978-1-319-20584-3 |pages=334 |edition=6th}}</ref>

Externalities can be either positive or negative. Governments and institutions often take actions to internalize externalities, thus market-priced transactions can incorporate all the benefits and costs associated with transactions between economic agents.<ref>{{cite journal |last1=Stewart |first1=Frances |last2=Ghani |first2=Ejaz |title=How significant are externalities for development? |journal=World Development |date=June 1991 |volume=19 |issue=6 |pages=569–594 |doi=10.1016/0305-750X(91)90195-N }}</ref><ref>Jaeger, William. ''[https://books.google.com/books?id=uhBkp5rmrXgC&pg=PA80 Environmental Economics for Tree Huggers and Other Skeptics]'', p. 80 (Island Press 2012): "Economists often say that externalities need to be 'internalized,' meaning that some action needs to be taken to correct this kind of market failure."</ref> The most common way this is done is by imposing taxes on the producers of this externality. This is usually done similar to a quote where there is no tax imposed and then once the externality reaches a certain point there is a very high tax imposed. However, since regulators do not always have all the information on the externality it can be difficult to impose the right tax. Once the externality is internalized through imposing a tax the competitive equilibrium is now Pareto optimal.