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An externality occurs in economics when the actions of one consumer or firm affect the well being or production of another consumer or firm with whom there is no direct business relationship. Examples of these kinds of technological externalities might include:

  • Pollution by a firm in the course of its production which causes nuisance or harm to others. This is an example of a negative externality.

  • An individual planting an attractive garden in front of his house may benefit others living in the area. This is an example of a positive externality.

  • An individual buying a telephone for the first time will increase the usefulness of telephones to people who might want to call him. This is an example of a network externality.

In contrast:

  • A property tycoon buying up a large number of houses in a town, causing prices to rise and therefore making other people who want to buy the houses worse off, is not causing a technological externality. Rather this is sometimes called a pecuniary externality, because the effect is through prices, and is considered part of the normal function of the market.

Externalities are important in economics because they may lead to inefficiency (see Pareto efficiency). Because the producers of externalities do not have an incentive to take into account the effect of their actions on others, the outcome will be inefficient. There will be too much activity that causes negative externalities such as pollution, and not enough activity that creates positive externalities, relative to an optimal outcome.

Many of the most important externalities in the economy are concerned with pollution and the environment. See the article environmental economics for more discussion of externalities and how they may be addressed in the context of environmental issues.

Supply and Demand

Externalities can be illistrated on a standard supply and demand diagram if the externality can be monetized. An extra supply or demand curve is added. One of the curves is the private cost that consumers pay for a given quanity of the good (marginal or average private cost) and the other curve is the cost that society pays for the good (the marginal or average social cost). Similarly there might be two curves for the demand or benefit of the good.

Negative Externality

This graphics shows a negative externality. The private cost is less than the public cost. If the consumers only take into account their own private cost they will end up at price Pp and quantity Qp, instead of the more efficient price Pe and quantity Qe. The result is inefficient since at the quantity Qp the benefit (a.k.a. the demand) is less than the societal cost, so society would be better off if the goods between Qe and Qp had not been produced.

Externalities and property rights

Ronald Coase argued that where property rights are clearly defined, individuals will organise trades so as to bring about an efficient outcome and eliminate externalities. This result is often known as the Coase Theorem[?].

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