Externalities are costs or benefits that affect third parties in a transaction. They can be positive or negative and disrupt market efficiency. Governments regulate to limit negative externalities and promote positive ones, such as education. Examples include criminalizing drugs and higher taxes on unhealthy products.
In economics, an externality is defined as a cost or benefit arising from a transaction involving various third parties who are not parties to the transaction. The effect can be a benefit to the third party, called a ‘positive externality’, or it can be a cost, called a ‘negative externality’. Externalities impair the efficiency of a market because the prices in individual transactions will not reflect the costs or benefits imposed by the externality. Governments will often try to explain these external factors through various methods of regulation.
An efficient market is one that finds the ideal price for the general welfare of society in the production of a good or in the provision of a service given supply and demand. There are few transactions that do not involve an unexpected externality that confers costs or benefits on society at large and disrupts this efficiency. This is because externalities are generally not considered by private companies and consumers when carrying out their transactions, as they are difficult to ascertain in the context of a single transaction.
The classic example of a negative externality is the polluting society. This hypothetical widget company takes into account the demand for their product, manufacturing costs, as well as any overheads in running their widget factory when determining their price. Likewise, the consumer will only consider what he wishes to pay to own a widget in deciding whether or not to buy the item. What neither side considers is the social cost of producing widgets, which pollutes the air surrounding every location where a widget factory is located.
An externality doesn’t have to be negative. For example, the growing prevalence of education in society is an example of an economic event with a variety of positive externalities. Any society populated by educated people will benefit from the knowledge derived from the time and money those people spend on their education. The technological and medical advances resulting from such knowledge will benefit not only those who make such developments, but also those in society who have access to the advances made by its educated citizens. These advances are examples of positive externalities.
Governments will seek to account for these factors through a variety of regulations in order to limit negative externalities and promote activities that lead to positive externalities. Criminalizing drugs in order to discourage their use and subsequent destructive effects such as an increase in violent crime is one method. Higher taxes on unhealthy products such as tobacco and alcohol are designed to discourage their purchase and consumption. Furthermore, governments can promote positive externalities through subsidies that reduce the cost of producing or consuming a good or service that has beneficial effects on its society.
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