Externalities, and why markets produce too much under a negative one and too little under a positive one

What externalities are. An externality is a benefit or a harm that a firm or a person causes to someone else, for which the one causing it is not paid (for a benefit) or not penalised (for a harm). The effect falls on a third party, outside the deal between buyer and seller, and there is no market in which it can be bought and sold. So the one who causes the effect bears none of its cost and receives none of its benefit.

It helps to separate two sets of costs and benefits:

• Private cost and private benefit: what the decision maker herself pays and gains.
• Social cost and social benefit: these plus the cost or benefit that falls on everyone else.

Social cost = private cost + external cost; social benefit = private benefit + external benefit. With no externality the two sets are the same.

Negative and positive externalities. The examples are our own.

• Negative externality: an action harms others without compensating them. A brick kiln on the edge of Ghaziabad sends smoke over nearby fields and homes, cutting crop yields and harming the lungs of people who buy no bricks from it. A family that bursts loud crackers late at night disturbs the sleep of the whole street.
• Positive externality: an action benefits others who pay nothing for the benefit. A family that vaccinates its child also protects the neighbours' children from the disease. A farmer in Himachal who keeps bees raises the fruit set in the neighbouring orchards.

Is the statement true? Yes, as a general rule. When an externality is left unpriced, the private market produces more than the efficient quantity of a good with a negative externality and less than the efficient quantity of a good with a positive one. The reason, and the conditions under which it holds, are set out below.

Why private choices go wrong. In a market each buyer and seller weighs only her own benefits and costs. A unit of a good is worth producing for society when its social benefit is at least its social cost; but the decision maker goes ahead whenever its private benefit is at least its private cost. When one member of a group decides, she does not take into account the effect of her action on the others. The external cost or benefit is therefore simply left out of the decision, and the quantity chosen is not the one that is best for society.

A negative externality: too much is produced. The kiln sells bricks in a competitive market at ₹8,000 a batch of 1,000 bricks. Each extra batch in a month costs it more than the one before, and each batch also does ₹1,000 of smoke damage to its neighbours (our own figures):

• The kiln produces every batch whose cost to it is no more than the price: 5 batches.
• Counting the smoke damage, only batches whose full cost to society is no more than the price, which measures what buyers value them at, are worth making: 3 batches.
• The market thus over-provides by 2 batches. On those two batches society loses ₹500 (8,500 − 8,000) and ₹1,000 (9,000 − 8,000), ₹1,500 a month in all, borne by the neighbours.

The same thing happens with common resources, which anyone can use but where one person's use leaves less for others. Each user ignores the harm her own use does to the rest, a negative externality, so the resource is used beyond its efficient level: this is the tragedy of the commons. Farmers who all draw on the same groundwater in a district of Punjab each pump as much as suits their own fields, and the water table falls for everyone. On a world scale, each country burns fossil fuel at the level that suits it, and total carbon release ends up far above what the environment can absorb.

A positive externality: too little is produced. In a village, a vaccine dose costs ₹500. Five families value vaccinating their own child at different amounts, and each vaccinated child also protects other children, a benefit of ₹200 to the rest of the village (our own figures):

• Left to themselves, only P and Q vaccinate: 2 children.
• Counting the benefit to others, 4 vaccinations are worth more than they cost: 4 children.
• The market thus under-provides by 2, and the village loses the ₹150 (650 − 500) and ₹50 (550 − 500) of net gain those two doses would have brought, ₹200 in all.

This is why goods such as education and health, which matter for the well-being of the whole economy, are not produced in adequate amounts if individuals are left to themselves, and the government may encourage their production or produce them itself. In the extreme case of a public good, which no one can be kept from enjoying and whose use by one does not reduce it for others, each person waits for others to pay and enjoys the benefit free; this free-rider problem arises from the positive externality, and a good worth more to the group than it costs may not be provided at all. Left to the market, a public good is supplied in an inefficient quantity.

What is lost. In both cases total gains to society are smaller than they could be. With a negative externality, units are produced whose full cost to society exceeds what buyers value them at; with a positive one, units that are worth more to society than they cost are never produced. In each case the lost gain is a loss to society as a whole, of the same kind as the deadweight loss that arises when a tax stops trades that would have benefited both sides.

Qualifications and remedies. The statement describes what happens when nothing makes the decision maker face the external effect. It need not hold when something does:

• Taxes and subsidies. A government that wants to discourage the making and use of a good, such as alcohol, can tax its producers and consumers; to encourage a good, such as education, it can subsidise them. A charge on each batch equal to the smoke damage would make the kiln count the ₹1,000 and stop at 3 batches; a ₹200 subsidy per dose would bring R and S in.
• Compulsory contributions. If everyone who benefits must pay a set share, the free-rider problem disappears. The government decides such provision by comparing the total benefit with the total cost.
• Property rights. Over-use of a common resource can be ended by defining property rights clearly, so that the owner can keep others out and the cost of using the resource is felt by those who use it.

Conclusion. Externalities are effects of one party's actions on others that no market prices. Because private decision makers count only their own costs and benefits, the statement is true: a good with a negative externality is over-provided, since the harm to others is left out of its cost, and a good with a positive externality is under-provided, since the benefit to others is left out of its value. The result holds unless taxes, subsidies, compulsory contributions or property rights make the decision maker take the external effect into account.