In economics, an externality is an indirect cost or benefit to an uninvolved third party that arises as an effect of someone else’s activity. Negative externalities can pose a fundamental problem to society. The story of Tony, a fisherman, and a new paper mill that pollutes the local river, shows what can happen when negative externalities are not internalized.
the full story
Tony, a fisherman, has been living in a house by the lake since he was young. Over the years, the lake is becoming more popular and one day a large hotel gets built. The hotel obscures all the sunlight and the guests leave their trash on the beach . To Tony these are negative externalities. Although, the good smell of the freshly roasted coffee from the coffee shop that opened right next to the hotel is a positive externality though
Things start getting complicated when a paper factory begins polluting the river that flows down the mountain into the lake where Tony and other fishermen earn a living. Can you think of the effects the factory may have on the community? You may pause the video and share your thoughts before we continue!
The paper factory is using the clean water from the mountain river. Through the production process, the water gets dirty and afterwards the polluted water is put back into the river. This water then kills a lot of fish downstream – a cost to society that no one covers. Tony and the fishermen start to fear for their existence. And then things get worse…
social behavior impact
The paper mill, which doesn’t factor the cost of the dead fish into their cost of production, is therefore charging too little when selling the paper. As a consequence, the paper is so cheap that the coffee shop starts using disposable cups where they were using porcelain before. This again leads to more production of paper, more polluted water, more fish dying and more trash on the beach. Tony is getting anxious.
To change the situation, the fishermen decide to stage public protests until the local government announces a new law.
The factory is now forced to fully internalize the costs of their waste management through the installation of filters. Soon after, the water is clean again and Tony and the other fishermen can go back to selling the same amount of fish they used to. And since the price of the paper goes up to cover the costs of the filtration systems, the coffee shops begin serving drinks in real cups again.
distortion of supply and demand
We can illustrate what is happening on a supply and demand chart with price and quantity demanded for the paper. In an unregulated market, the factory supplies its products based on so-called private costs, such as construction, salaries and the raw materials. Demand meets supply accordingly.
If the paper factory would have added the costs of the damages that it causes to society, the supply curve would have shifted to the left, leading to an equilibrium reflecting the true costs, including the social costs. Now the price of paper is higher and the quantity of paper demanded is lower.
tragedy of the commons
Pollution and other negative externalities are especially prevalent where people lack the same moral values and where things tend to be free of charge. Such is the case with water or air.
Fishing at high seas is such a case. Since no one can fully control the oceans and the high sea doesn’t really belong to anyone, everyone takes as much as they can – a phenomenon called the tragedy of the commons.
To combat negative externalities and avoid such a tragedy, we can do four things: create public awareness, assign property rights appropriately, force the internalization of negative externalities or turn to regulation and fines.
to prevent negative externalities
Let’s summarize: Externalities are consequences of an activity experienced by a third party. Negative externalities that are not internalized, distort supply and demand at the expense of third parties. To avoid market distortion and a tragedy of the commons, we can combat negative externalities.
Ready to help us think how to do that in order to curb CO2 emissions?
what do you think?
People that drive cars that run on petrol cause emissions, including CO2 which is responsible for air pollution and climate change. In order to reduce emissions, some governments give their citizens a financial incentive if they buy an electric car. Imagine you are the Minister of Transportation in your country. Could you think of another way to increase the number of electric cars on the streets by applying the concept of externalities? Please write down your ideas in the comments below!
- Externality – Wikipedia
- What Are Externalities? – Imf.org
- How Do Externalities Affect Equilibrium and Create Market Failure? – Investopedia.com
- Listen to this econtalk episode with Mike Mungers on subsidies and externalities.
- Read this overview on externalities by Brian Caplan.
- Watch Sprouts video on Tragedy of the commons.
Here is a simple 45-minute class activity for high school or college students:
- Start by asking your students to write down one behavior of others that indirectly affects them negatively in class — say when others are being too loud. Then collect the answers, read some out loud and explain that economists call such things negative externalities. 5 mins.
- Then play the Sprouts video on the topic.
- After playing the video, let the students, in groups of two, think of ways to reduce CO2 emissions (or another externality) by forcing producers to internalize their full costs. How would they go about it? Who should be paying for what and how? And how would such a law change the supply and demand for certain related and unrelated products and services? 20 mins.
- Afterwards, let some groups present their findings. 5-10 mins.
- End the class with a group discussion or some examples from the real world. 5 mins.
- Script: Jonas Koblin and Jonas Jacquet
- Artist: Pascal Gaggelli
- Voice: Mithril
- Coloring: Nalin
- Editing: Peera Lertsukittipongsa
- Sound Design: Miguel Ojeda
- Production: Selina Bador