Are you familiar with the word “externality“? Don’t be alarmed; even if you are not familiar with the term, there is a great chance that you have encountered it in one way or another. The problem with the finance media is that they use niche jargon to communicate to a wide and diverse audience. It is the audience’s responsibility to seek clarity of concepts and terminology they do not understand, but this can become overwhelming if they are bombarded with a great number of foreign terms. Readers who are not familiar with the term will have a better understanding of the concept of externality by the end of this post.

DEFINITION

Investopedia.com describes externality as “a cost or benefit caused by a producer that is not financially incurred or received by that producer.” Externality explains a situation where positive or negative outcomes do not impact those who caused it. You may be thinking that you are familiar with this concept, but you didn’t know it had an official label. If you are still a bit confused, some examples will help make the economic concept clearer.

There are two forms of externalities, negative and positive. We will first cover negative externalities, followed by positive ones. Keep in mind that a “party” can be an organization, a company, or an individual/individuals. 

NEGATIVE EXTERNALITY

A negative externality occurs when a third party experiences a less than desirable by-product of another party’s action. The other party tends to not receive this less than desirable by-product during normal operations. Our first example of a less than desirable by-product is pollution. 

Air Pollution

A company that creates air pollution as a byproduct of their business doesn’t receive or pay the cost of the negative results of pollution. A third party, such as the environment or a community in the vicinity of the waste, receives the harmful results of the pollution.

Parties that don’t bear any cost for creating negative externalities tend to not have any incentive to adjust their operations. Due to this, other parties, such as individuals, environmental organizations, and local or federal governments, make efforts to get the producers of negative externalities to adjust their behaviors.

There are many ways one party can get another party to curtail their production of negative externalities. In the case of pollution, different parties have taken different actions to combat it. 

We have seen individuals boycott companies in order for a company to change its behavior. They also encourage other individuals to not support a business until the business changes their business practices. Environmental organizations also put pressure on companies to be more conscious of their impact on the environment by bringing the problem to a large mass of people. Also, local and federal governments may intervene due to pressure from their constituents to do something. Governments can create laws or fine a company based on their practices. Companies tend to increase the prices of their products to offset rising costs to do business. They will also find more efficient ways to operate while maintaining profits and reducing their carbon footprint. 

Noise Pollution

Another example of a negative externality is the playing of loud music. Loud music is a form of noise pollution. Not everyone enjoys music played at a high decibel, especially at an inappropriate time. The person playing the music is enjoying the experience, while neighbors are being disturbed. Imagine having to be at work early in the morning and your neighbor is playing loud music at midnight. This will affect the quality of your day on many levels. You will not be your best at work, and depending on the type of career, you might be putting other coworkers and individuals at risk. 

In situations like this, you may be compelled to confront the individual or call the authorities. If it is an organization instead of an individual playing loud music past a certain time, they may face other consequences. If the organization did not seek permission at first, they would definitely be shut down and even fined by the local municipality. This situation proves that there is a procedure to be followed if an organization wants to play loud music late. The procedure will take into consideration location and how frequently the event takes place. It will also give the community early warning to be prepared for the event.

Overconsumption of Alcohol

A final example of negative externality is a person consuming too much alcohol. As a result of a person consuming too much alcohol, they may lose inhibition and become a nuisance to those around them. They may be hard to deal with and have to be taken care of by those around them. Drunkenness can lead to violent encounters with other individuals and the authorities if a drunk individual chooses to respond violently. This example illustrates that even though the person consuming the alcohol is having a great time, sometimes that great time is at the expense of those around them.

Society has adapted to drunkenness and has been treating it as a public health issue instead of an individual problem. There are AA (Alcoholics Anonymous) meetings that help individuals in their fight with alcoholism. Society has taken great measures to destigmatize alcoholism so that people who are struggling with the disease can seek help. At the same time, society holds individuals accountable for any damage that may be a result of a person being under the influence.

POSITIVE EXTERNALITY

Now that we have covered negative externality, it is time to cover positive externality. Tejvan Pettinger, in his article he contributed to economichelp.org, says that positive externality “occurs when the consumption or production of a good causes a benefit to a third party.” In other words, one party benefits from the action of another party even though they did not participate in the action that creates that benefit. We will go over some examples below.

Education

One popular example many like to use when discussing positive externality is the consumption of education. The person who seeks education must go through the rigor of learning at a cost of time and money. Individuals who did not pursue education benefited from the positive actions, experiences, and products created by those who did.

A simple conversation between a trained chef and a person who is not trained in the arts of culinary can be very beneficial for the untrained. They are receiving knowledge without having to commit to a culinary arts education. 

Research & Development

Another example of positive externality is research and development. The entity that conducts research & development is not the only one that benefits from the results. Other parties can benefit from the results of research & development without infringing on the rights of those that conduct the research & development.

As pertaining to the pharmaceutical industry, many developing countries benefit from the research of large companies by making generic drugs when a patent is up. Many large companies file for patents that allow them to benefit financially from a development exclusively. When that patent is up, other companies that do not have the resources to conduct major research can replicate the once patented products.

FINAL THOUGHT

Understanding externality will help individuals recognize that within a society the actions of a group, an organization, or an individual can have a positive or negative impact on other groups, organizations, or individuals. Most people are aware of this, but they fail to notice that negative by-products are not always intentional or recognized by those that cause them. Also, we are able to see that incentives can be another tool to dictate positive behavior instead of only punishment. 

In many cases the creators of externalities are not impacted by the result of an externality unless a third party intervenes. In the case of pollution, nonprofit environmental groups and local and federal governments play a major role in tackling that issue. In the case of overconsumption of alcohol, the local and the federal government have created laws to protect society, who may or may not engage in the overconsumption of alcohol. These laws come in the form of bars and clubs not being able to serve alcohol past a certain time. Also, any store that sells liquor, such as a grocery or liquor store, may not be able to sell liquor past a certain time depending on their location.

As for research & development, an organization or business may not conduct certain research due to the fact that they will not be able to monetize the results. That is why many research groups and nonprofit groups rely on donations and government funding to conduct research. Also, incentives may be provided in the form of patents to businesses that research and develop new health products. This is the argument that pharmaceutical companies use in support of health products. They argue that they need to be able to reap the benefits of the research and development in order to continue researching. 

Understanding externality can help people appreciate that individuals in a society do not live in a vacuum independent of others. It can also help individuals understand that the actions of one party can have an unintentional impact on another party. Also, if there are no groups monitoring negative externalities, then many negative outcomes will go unchecked.