negative externality

negative externality, in economics, the imposition of a cost on a party as an indirect effect of the actions of another party. Negative externalities arise when one party, such as a business, makes another party worse off, yet does not bear the costs from doing so. Externalities, which can be either positive or negative to the affected parties, are a form of market failure resulting in inefficient market outcomes. Negative externalities are an important concept in environmental economics, in which pollution represents a tremendous cost borne by outside parties.

In competitive markets, the prices of goods and services are generally determined by supply and demand. The seller will sell as long as they can do so at a price that exceeds their cost to produce the good or service, and the buyer will purchase as long as they can do so at a price that is below the perceived marginal utility (personal value) that the good or service will provide. In an ideal, efficient market, goods and services are produced to maximize the economic benefit for both the seller, who gains a profit, and the buyer, who gains utility.

However, market failures, in which the outcome of an economic transaction is not completely efficient, are common, and externalities are a classic example. Negative externalities occur when a transaction has a cost that neither the buyer nor the seller are forced to pay. For example, a factory may release air pollution into the environment, incurring large social costs that neither the factory owners nor the consumers purchasing their product pay. Because the factory does not pay the costs of this negative production externality, the factory will produce a higher quantity of goods than would be socially optimal, leading to higher social costs—parents paying for asthma treatment, farmers experiencing crop damage from acid rain, global warming, and so on.

Another type of negative externality is the negative consumption externality, in which the consumption of a good reduces the well-being of others who are not compensated for this harm. Cigarette smoking is a common example, in which one’s consumption affects others as a result of the health hazards of secondhand smoke. The purchase and use of large sports utility vehicles (SUVs) is also associated with a number of negative consumption externalities, including greater greenhouse gas emissions, heavier wear and tear on public roads, and the increased risk of more dangerous accidents imposed on drivers of smaller vehicles.

Private sector solutions can correct the market inefficiencies created by negative externalities in some situations. The Coase theorem suggests that the distribution of the costs of negative externalities can be negotiated by the affected parties directly with the offending party. For example, homeowners near a smelly cattle feedlot could agree to buy out the operation using money collected annually in a fund. Sometimes the offending party can negotiate to pay the cost. For example, rather than shut down production, a water-polluting factory could financially compensate the affected fishers downstream for their reduced catches. However, the Coase theorem functions only if the costs of negotiation are low, property rights are well defined, and there are no asymmetries in information among the negotiating parties, conditions that are frequently unrealistic. Blame for a negative externality is often hard to assign, and different parties may be affected to different degrees, making a fair negotiation impossible. In the case of the water-polluting factory, for example, the factory might argue that they are not the only source of pollution in the river, and it might be difficult to precisely negotiate the losses of different fishing operations along the waterway and the extent to which losses can be attributed to the factory in question.

For these reasons, negative externalities are frequently addressed by government interventions. In some cases, transactions with externalities may be directly regulated, or even banned, by governments. Smoking bans, for instance, are enacted to reduce the public’s exposure to secondhand smoke in restaurants or other locations. Minimum car insurance mandates serve to combat the negative externalities presented by uninsured drivers. Similarly, environmental regulations may strictly limit how waste can be disposed of, how much of a particular chemical can be emitted, or what chemicals can be included in consumer goods. Governments may also establish permit markets, in which a target level of pollution is deemed acceptable, and parties who wish to be allowed to pollute must bid for the right to do so. This scheme provides financial incentives to move away from production that pollutes the environment while still allowing flexibility among firms who may face different abatement costs.

British economist Arthur Pigou proposed that governments tax producers in proportion to the harm their production caused to third parties. Ideally, such Pigouvian taxes return the external effects of the transaction to the parties involved (“internalizing an externality”), thus restoring the efficiency of the markets involved. One common example of a Pigouvian tax is a carbon tax. The idea behind a carbon tax is to assess the costs to society of the emission of carbon dioxide and force consumers and producers to bear that cost with a tax, effectively raising the cost of carbon-intensive industry. By raising prices, it makes the emission of carbon dioxide less economical, encouraging businesses to produce less carbon and consumers to switch to alternatives. Pigou’s idea can also be applied to positive externalities to justify government subsidies that lower the costs of providing or accessing beneficial services, such as education, health care, or energy efficiency, for example.