Externalities in the Economy

Externalities are pervasive and significant phenomena in modern societies. The term externalities refer to the economic effects which occur from the production or the use of goods to other parties or economic units. It is said that public goods and externalities are not un-related. In other words, public goods and externalities are related. Externalities may affect a large number of people in a uniform manner, in which case the externality is essentially a public good (or public “bad”).

For example, education increases the skills and general welfare of the person being educated and may in addition, make the person better citizen. That is, the person’s behavior in political process may be more wise and informed, and an informed may make better political decisions. Since, such decisions affect every one, the education of each person produces an external benefit that accrues to the
members of the community and the nation in which person reside. This external benefit is a public good that is jointly produced along with the private goods (marketable skills) resulting from education.

Similarly, air pollution generated by an iron mill’s smoke and the exhaust of automobiles are public bads that are produced jointly with private goods (iron mills and private transportation). Again, the railways using a lot of coal in firing steam locomotives put the residential and other areas near the railway loco sheds to a lot of suffering on account of the smoke nuisance. These are the cost to the society but not to the individual undertaking.

In the above examples, public goods, i.e., benefits and public bads that are produced with private goods are known as externalities. These are the cost to the society but not the individual undertaking. This causes of divergence between private cost (internal cost) and social marginal cost or external cost of benefit, of the good in question. Market takes into account internal costs and not the social marginal cost or external cost (or benefit) of the good in question. Consumer’s reveal their preferences for the benefits which are wholly internalized (rival) but not for the external benefits, i.e., purification of air (non-rival). Thus, market fail to achieve efficient allocation of resources when externalities are present.

To be more clear, let the production of a commodity, say iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, have two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron; and (ii) the costs borne by the members of the community in the form of air pollution damages. Market takes into account first component of the above costs but not the second. This is the cause of divergence between private cost (internal cost) and the social marginal cost (external bads). Hence, markets fail to achieve efficient allocation of resources when externalities, i.e., external costs or benefits are present.

Thus, externalities can take many forms. For example, external benefits from education: children gain from having educated parents; society benefits in so far as education reduces crime, social un-rest, unemployment and welfare costs; society benefits from an educational system that inculcates acceptable social values, improves communication and strengthen democratic institutions, on the (external bads) side are many forms of pollution and other disseminates such as congestion and noise etc.

i) Externalities in the form of external benefits: Problems of social good-type arise not only in the budgetary context but also wherever private consumption or production activities generate external benefits. Suppose, for instance, that A derives benefits being inoculated against polio but this also benefits others, since the number of potential carriers and hence the danger of infection, is reduced. Similarly, by getting educated, A not only derives personal benefits but also makes it possible for others to enjoy association with a more educated community. Since, large number of other consumers may be affected, market does not work and a budgetary process is needed to secure preference revelation. But budgetary intervention in this case will not involve full budgetary provision: rather, it will take the form of subsidy to private purchases.

ii) Externalities in the form of external costs or bads: Let us now consider a case of a commodity which generates external costs or bads. Suppose, the production of iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, has two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron, and (ii) the costs borne by member of community in the form of air pollution damages. However, the second component of cost is not taken into account by the market. In fact, private activities, whether in production or consumption frequently give rise to external costs which are not accounted for by the market. Hence, public (Government) intervention is needed to get this part of the cost to be internalized.

iii) Efficiency and equity problems: In the first place, failure to account for external costs leads to an over supply of production question (i.e., here iron) and an under supply of the benefits (i.e., clean air) which are reduced by pollution. This is the efficiency problem. If the damage cost of pollution were internalized, resource use would become more efficient. The price of iron would be higher, less iron would be produced and the air quality would be improved.

Second, the existence of pollution poses distributional or equity problems. Through, the loss of environmental quality, consumers of air are forced to subsidize consumers of iron, much as they would if a tax were imposed on them (consumers of air) and transferred to the latter (i.e., consumers of iron). Moreover, the incidence of pollution damage may fall with different weight upon low income and high income families, and this affects the distribution of real income. The same goes for the cost of pollution prevention and the net gains to be derived there from.

iv) Efficient solution: It should, however, be noted that air is a public property, it is a social good. The principle of exclusion does not apply. Hence, market fail to take into account external costs or the damages caused by air pollution. The benefits of this good are shared by all those who are damaged by pollution.

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