An externality is an economic term referring to a cost or benefit incurred or received by a third party who has no control over how that cost or benefit was created.
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- An externality can be both positive or negative, and can stem from either the production or consumption of a good or service.
- The costs and benefits can be both private—to an individual or an organization—or social, meaning it can affect society as a whole.
- Externalities are negative when the social costs outweigh the private costs.
- Pollution emitted by a factory that muddies the surrounding environment and affects the health of nearby residents is a negative externality.
- Positive externalities occur when there is a positive gain on both the private level and social level.
- The effect of a well-educated labor force on the productivity of a company is an example of a positive externality.
Solutions for Positive and Negative Externalities:
- Subsidies: Subsidiesare 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 consumption of goods and services and is represented by a decrease in supply. The government should impose Indirect Taxeson products with negative externalities. Education and regulation are also ways of controlling the quantity consumed and produced.
- Moral codes: Moral codes guide individuals’ behavior. For example: littering. The likelihood of being fined may be small, but moral codes provide an incentive to refrain from littering.
- Charities: Charities channel donations from private individuals towards fighting to limit behaviors or promoting behaviors. For example: Donations to help protect the environment.