An externality is a cost or benefit of an economic activity experienced by an unrelated third party.
Externalities are costs or benefits of market transactions that are not reflected in the market price and that affect individuals who are not participating in the market.
The external cost or benefit is not reflected in the final cost or benefit of a good or service.
Externalities arise whenever the actions of one economic agent make another economic agent worse or better off, yet the first agent neither bears the costs nor receives the benefits of doing so.
Example: a steel plant that pollutes a river used for recreation
Externalities can be classified on the following basis
1 Negative externality
A negative externality is a negative consequence of an economic activity experienced by an unrelated third party.
Externalities arise when action of one party makes another party worse off without compensation
Negative externalities are costs of market transactions that are not reflected in the market price and that affect individuals who are not participating in the market.
When a negative externality is present the private market would provide too much of the good hence creating loss to the society or dead weight loss
The majority of externalities are negative.
Negative externalities can occur in consumption or production
Negative consumption externality occurs when an individual’s consumption reduces the well-being of others who are not compensated by the individual.
Example: passive smoking, using a car and emitting carbon contributing to global warming.
Negative production externality occurs when a firm’s production reduces the well-being of others who are not compensated by the firm.
Example: air, water and noise pollution.
2 Positive externalities
A Positive externality is a benefit of an economic activity enjoyed by an unrelated third party.
Positive externalities are benefits of market transactions that are not reflected in the market price and that accrue to individuals who are not participating in the market.
Positive externalities refer to costs or benefits of production activities which are not reflected in the market price but have effect on the wellbeing of others
In the presence of positive externalities private market produce too little of the goods hence dead weight loss
Positive Externalities can be production and consumption
Positive production externality occurs when a firm’s production increases the well-being of others but the firm is not compensated by those others
For example: Infrastructure development such as bypass and SGR may benefit real estate agents who transact properties in the area.
Real estate prices would likely increase due to better accessibility, and the agents would be able to earn higher commissions.
Positive consumption externality occurs when an individual’s consumption increases the wellbeing of others but the individual is not compensated by those others.
Example: Beautiful private garden that passers-by enjoy seeing and vaccination against infectious diseases like Corona
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