Externalities, with examples, and internalising the externality from education

What an externality is. An externality is a benefit or a harm that the action of a firm or a person causes to others who are not part of the decision, and for which the one acting is neither paid nor penalised. No market exists in which such an effect is bought or sold. It is negative when the effect on others is harmful and positive when it is beneficial.

Negative externalities: examples. Our own.

• A stone-crushing unit on the edge of a village in Rajasthan fills the air with dust. Villagers' health and crops suffer, but the unit pays nothing for the damage.
• A late-night wedding band in a residential lane keeps the neighbours awake; the family that hired it does not compensate them.
• Each extra car on a crowded Bengaluru road at 6 p.m. slows every other driver, a cost the extra driver does not bear.

Positive externalities: examples. Our own.

• A household that keeps its rooftop water tank covered and clean breeds no mosquitoes, which lowers the risk of dengue for the whole lane.
• A beekeeper's bees pollinate the mango orchard next door, raising the neighbour's crop at no charge.
• A shopkeeper who lights the pavement outside his shop at night makes the street safer for everyone walking past.

Why the market gets the quantity wrong. The person acting compares only her own benefit with her own cost. With a negative externality she ignores the harm to others, so there is more of the activity than is best for society. With a positive externality the people who benefit pay nothing, so she gains less than society does and there is too little of the activity.

The externality from education. Education benefits the student, through higher earnings and a fuller life, and these private benefits are what she weighs when deciding how much to study. It also benefits others who pay nothing for it. For example, an educated worker can raise the output of the team she works with, a literate parent can help her children with their schooling, and better-informed citizens can take part more fully in public decisions. Education therefore carries a positive externality. Left to themselves, families weigh only the private benefit against the fees and the earnings given up, so they buy less education than is best for society.

How the government can internalise it. To internalise an externality is to make the person who decides take its effect on others into account. For a positive externality this means paying her for the benefit she gives to others, so that her private gain moves up to the social gain. To encourage the production or consumption of a good such as education, the government can provide subsidies to both producers and consumers:

• Subsidies to schools and colleges (producers): grants that let them charge lower fees, or teach free, so that more students enrol.
• Subsidies to students and their families (consumers): scholarships, fee waivers, free textbooks and uniforms, or a meal at school, which lower the private cost of each extra year of study.
• Size of the subsidy. The aim is a subsidy roughly equal to the benefit that one more student's education gives to others; families then choose as if they received that benefit themselves, and enrolment rises towards the level that is best for society.

Conclusion. An externality is an unpriced effect of one party's action on others, harmful (dust, noise, congestion) or beneficial (clean tanks, pollination, lit streets). Education has a positive externality, so the market gives too little of it; the government internalises the externality by subsidising schools and students so that the private reward to education reflects its benefit to society.