What are Externalities?

In the abstract model of an ideal economy, we affect others as we produce and consume. However, any benefits we give others or burdens we impose on them are accepted because they are taken into account in the exchange that connects production and consumption. Consumers purchase the products they consume, paying producers for the trouble they took to produce. In real economies some of the benefits and burdens of production and consumption are involuntarily imposed on third parties who are not part of any exchange or agreements with producers or consumers. Economists call these side effects on third parties "externalities."

When third parties find the side effects useful or desirable, the externalities are positive externalities. When the side effects are harmful or undesirable, they are negative externalities. An externality can be positive to some and negative to others--if Maria is playing very loud music in her apartment with cardboard thin walls, she gives positive externalities to those who like the music and negative externalities to those who do not like it. Once you start looking for externalities, you find them everywhere.

Public goods and the problem of the commons are two special cases of externality effects that have special names and that are sometimes separated from the discussion of externalities. Public goods can be thought of as positive externalities gone wild, where virtually everything is externality. The problem of the commons is a special case of negative externalities in the production of a good. Externalities, public goods, and the problem of the commons occur when property rights are defective, either because they have not been properly assigned, because it is impossible or very difficult to assign them, or because they are not easily enforced.

A brief introduction to externalities and the problem of the commons was given earlier, along with some problems to work and questions to ponder.

The primary reason economists are interested in externalites, public goods, and the problem of the commons is that their presence can lead to economically inefficient outcomes. Let's begin to see why.

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Copyright Robert Schenk