Introduction to Externalities

Externalities are a form of market failure. Externalities are defined as the spillover effects of the consumption or production of a good that is not reflected in the price of the good. For example, the production of steel results in pollution being released into the air, but the cost of the pollution to the environment is not reflected in the price of steel.

1. Private Cost

The private cost is the price of an activity to an individual consumer or firm.

2. Social Cost

The social cost is the total cost of an activity not just to the firm but the rest of society as well.

3. Private Benefit

The private benefit is the benefit received by an individual or a firm by consuming and producing a good respectively.

4. Social Benefit

The social benefit is the total benefit to society from an economic activity.

Types of Externalities

In a free market, consumers and producers and owners of Factors of Production seek to maximize their own returns, prices, and profits play a key role in market mechanisms. Any intervention leads to distorted signals and misallocation of resources.

1. Positive Externalities

Positive externalities are the benefits experienced by these third parties as a result of consumption or production; in contrast, negative externalities are the harms to those third parties. Because positive externalities are primarily beneficial to society as a whole, they are to be promoted whenever possible.

2. Negative Externalities

Negative externalities are the costs or harmful consequences experienced by a third party when an economic transaction takes place (i.e. when a good is either produced or consumed).

Solutions For Externalities

Solutions For Externalities

1. Government Solutions


Subsidies are a form of support given to producers that help reduce the cost of production which results in an increase in production and consumption. Goods that governments want to increase the consumption of are subsidized. Subsidies should be provided for goods with positive externalities.

Indirect Taxes

An indirect tax is a tax applied to the manufacture or sale of goods and services. Indirect taxes discourage the consumption of goods and services and is represented by a decrease in supply. The government should impose Indirect Taxes on products with negative externalities.

Education and regulation are also ways of controlling the quantity consumed and produced.

B. Private Solutions

Moral Codes

Moral codes guide individuals’ behavior. For example: littering. The likelihood of being fined may be small, but a civic sense may provide an incentive to refrain from littering.


Charities channel donations from private individuals towards fighting to limit behaviors or promoting behaviors. For example: Donations to help protect the environment.

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1 thought on “Introduction to Externalities”

  1. great job Prateek.

    the graphics are really good. they are well done and very helpful in understanding your article.

    s. celly


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