# Understanding Externalities: Positive and Negative Economic Impacts

## What Is an Externality?

An externality occurs when an activity by one party causes a cost or benefit to another party. These effects can be either negative or positive. A negative externality imposes an indirect cost, such as pollution from a factory, which affects the health and environment of surrounding communities. Conversely, a positive externality provides an unintended benefit, like improved public education systems leading to a more skilled workforce, which aids the broader economy.  

### Key Takeaways

*   Externalities are the unintended costs or benefits experienced by third parties when a good or service is produced or consumed, and they can be positive or negative.
*   Negative externalities, like pollution, often arise when the social costs incurred exceed the private benefits, justifying government intervention through taxation or regulation.
*   Positive externalities, such as education and research, offer societal benefits beyond the private gains, sometimes warranting subsidies to promote them.
*   Externalities are a significant focus of economic policies, as they represent market inefficiencies that often require corrective actions to align private and social interests.
*   Economists use the cost-of-damages and cost-of-control methods to assess externalities, evaluating both the impact and the steps needed to manage them effectively.

![Externality Definition & Examples](https://www.investopedia.com/thmb/CrHOgeSgNDKjJi09W9U_p1Xmwvo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Investopedia-terms-externality-ad87b09c98a14f2489bfc7a298483838.jpg)

*— Investopedia / Madelyn Goodnight*

## How Externalities Impact Economic Activities

Externalities happen when the production or consumption of a good or service affects another party, which is often unrelated..

Most externalities are technical. Technical externalities have an impact on the consumption and production opportunities of unrelated third parties, but the price of consumption does not include the externalities. This exclusion creates a gap between private [gains](https://www.investopedia.com/terms/g/gain.asp) or losses and those of society.

The action of an individual or organization often results in positive private gains but detracts from the overall economy. Many economists consider technical externalities to be market deficiencies, and this is the reason people advocate for government intervention to curb negative externalities through taxation and regulation.

Externalities were once the responsibility of local governments and those affected by them. So, for instance, municipalities were responsible for paying for the effects of pollution from a factory in the area, while the residents were responsible for their healthcare costs as a result of the pollution. After the late 1990s, governments made producers accountable for the costs of externalities.

> **Fast Fact**
>
> Many companies pass on externality costs to consumers through price increases.

## Different Forms of Externalities in Economics

Externalities can be broken into two different categories. Externalities can be measured as good or bad, as the side effects may enhance or be detrimental to an external party. These are called positive or negative externalities. They can also be classified by how they occur.  

### The Realities and Costs of Negative Externalities

Most [externalities are negative](https://www.investopedia.com/terms/t/truecosteconomics.asp). Pollution is a well-known negative externality. A company might cut costs and increase profits by adopting environmentally harmful operations. The corporation realizes costs in the form of expanding operations, but also generates returns that are higher than the costs.

However, the externality also increases the aggregate cost to the economy and society, making it a negative externality. Externalities are considered negative if the [social costs exceed the private costs](https://www.investopedia.com/ask/answers/092916/how-do-property-rights-affect-externalities-and-market-failure.asp).

### Exploring the Benefits of Positive Externalities

Some externalities are positive. Positive externalities produce gains both privately and socially. Company [research and development](https://www.investopedia.com/terms/r/randd.asp) (R&D) can be a positive externality. R&D increases the private profits of a company but also has the added benefit of increasing the general level of knowledge within a society.

Similarly, the emphasis on education is also a positive externality. Investment in education leads to a smarter and more intelligent workforce. Companies benefit from hiring employees who are educated because they are knowledgeable. This benefits employers because a better-educated workforce requires less investment in employee training and development costs.

### Understanding Production-Based Externalities

A production externality occurs when industry operations have side effects. This is often the type of externality used as example, as it is easy to envision an environmental catastrophe caused by improperly stored chemicals by a chemical company. An externality arises from the company’s production methods or waste management.  

### Unpacking Consumption-Based Externalities

Externalities may also occur based on when or how a consumer base utilizes resources. Consider the example of how you get to work. Those who choose to drive are creating a pollution externality by driving their own car. Those who choose to take public transit or walk are not causing the same externality. Instead of a side effect occurring because something is being produced, an externality is caused because of an item being consumed.

> **Important**
>
> These four types of externalities above are often combined to define a single externality. For example, an externality may be a positive production, negative production, positive consumption, or negative consumption externality.

## Addressing Externalities: Potential Solutions and Strategies

There are solutions that exist to overcome the negative effects of externalities. These can include those from both the public and [private sectors](https://www.investopedia.com/terms/p/private-sector.asp).

### Taxes

Taxes are one solution to overcoming externalities. To help reduce the negative effects of certain externalities such as pollution, governments can impose a tax on the goods causing the externalities. The tax, called a [Pigovian tax](https://www.investopedia.com/terms/p/pigoviantax.asp)—named after economist Arthur C. Pigou—is considered to be equal to the value of the negative externality.

This tax is meant to discourage activities that impose a net cost to an unrelated third party. That means that the imposition of this type of tax will reduce the market outcome of the externality to an amount that is considered efficient.

### Subsidies

[Subsidies](https://www.investopedia.com/terms/s/subsidy.asp) can also overcome negative externalities by encouraging the consumption of a positive externality. One example would be to subsidize orchards that plant fruit trees to provide positive externalities to beekeepers.

This nudge has the potential to influence behavioral economics, as additional incentives one way or another way dictate the choices that are made. The subsidy is often placed on an opposing item to detract from a specific activity as well. For example, government incentives to upgrade to more energy-efficient renovations subtly discourages consumers against options with more externalities.

### Other Government Regulation

Governments can regulate to offset externalities. Regulation is considered the most common solution. People look to governments to legislate against negative externalities. Several examples include environmental regulations or health-related legislation.

The primary issue with government regulation of externalities is the need for consistent and reliable information to track the externality is being managed or overcome. Consider regulation against pollution. The government put forth resources to ensure that the legislation put in place is actually being followed, including holding bad actors accountable for not properly addressing their externality.

## Real-World Examples of Externalities

Many countries around the world enact [carbon credits](https://www.investopedia.com/terms/c/carbon_credit.asp) that may be purchased to offset emissions. These carbon credit prices are market-based that may often fluctuate in cost depending on the demand of these credits to other market participants.

One program within the United States is the Regional Greenhouse Gas Initiative (RGGI). The RGGI is made up of 12 states: California and 11 Northeast states. RGGI is a mandatory cap-and-trade program that limits carbon dioxide emissions from the power sector.

Agencies have caps on externalities but can trade to adjust them. Agencies that struggle managing their externality (i.e. pollution) may need to purchase additional credits to have their cap increased. Other agencies that conquer their externality may sell part of their cap space to recover capital likely used to overcome their externalities.  

## How Do Externalities Affect the Economy?

Externalities may positively or negatively affect the economy, although it is usually the latter. Externalities create situations where public policy or government intervention is needed to detract resources from one area to address the cost or exposure of another. Consider the example of an oil spill; instead of those funds going to support innovation, public programs, or economic development, resources may be inefficiently put towards fixing negative externalities.

## What Is the Most Common Type of Externality?

Most externalities are negative, as the production process often entails byproducts, waste, and other consequential outcomes that do not have further benefits. This may be pollution, garbage, or negative implications for worker health. Many externalities are also related to the environment, as the mechanical nature of manufacturing and product distribution has many detrimental impacts on the environment.

## How Can You Identify an Externality?

Companies must be mindful of their entire production process when assessing production externalities. This includes not only implications of the final product but residual impacts of byproducts, disposal of items not used, and how antiquated equipment is handled. This also includes projecting outcomes of items yet to occur, such as waste yet to be properly disposed of.

Consumers can identify consumption externalities by being mindful of the inputs and outputs that go beyond what they are attempting to achieve. Consider an example of an individual consuming alcohol. A consumer must be mindful that excessive drinking may lead to noise pollution, an unsafe environment, or adverse health effects.

## How Do Economists Measure Externalities?

Economists use two measures to evaluate an externality. First, economists use a cost-of-damages approach to evaluate what the expense would be to rectify the externality. As we may be seeing with greenhouse gas emissions, some externalities may extend beyond the point of repair.

Another method of measuring externalities is the cost of control method. Instead of fixing the externality, economists measure what preemptive and preventative steps can be taken to stop the externality from occurring. Similar to how an actuary assesses a financial value to an event, economists may assign multiple financial measurements to an externality.

## The Bottom Line

An externality is a byproduct of a primary process. This side effect may be good or bad and may be caused by a production process or consumption process. Many externalities relate to the environment due to the nature of company and individual actions, though there are many ways governments, companies, and people can take responsibility to both prevent and rectify externalities.

> **Article Sources**
>
> 1.  Center for Climate and Energy Solutions. "[Regional Greenhouse Gas Initiative (RGGI)](https://www.c2es.org/content/regional-greenhouse-gas-initiative-rggi/)."