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Externality

An externality is the unintended and uncompensated effect of one economic agent on a third party. An externality can also be called an external effect, an external (dis)economy, or an external cost (benefit).

Alfred Marshall first described external economies in the 1st edition (1890) of his textbook Principles of Economics, referring to "all matters of Trade-knowledge", including both market intelligence and technical know-how. His student and successor, Arthur Pigou, in his 1920 book Economics of Welfare, notes that external effects make the market inefficient, proposing the Pigou tax to remedy that. Pigou refers back to Marshall's spillovers[1] and writes about what we now call principal/agent problems but also notes what we now call externalities: the positive effects on neighbours of outdoor lighting, the impact of afforestation on the local climate, and the injury caused by smoke from chimneys.

Jacob Viner (1931 ZNatOek) distinguished between pecuniary and technological external effects. The latter are the same as Marshall's. Pecuniary externalities occur when the actions of one company affect another company through the market. An increase in supply by the first company would lower prices for both companies. Pecuniary externalities do not pose an efficiency problem. Tibor Scitovsky (1954 JPE) distinguishes four types of technological externalities, from consumer to consumer, from producer to consumer, from consumer to producer, and from producer to producer. The example he gives for consumption externalities on consumption is, in fact, altruism or empathy: I take pleasure from you enjoying your ice cream. He dismisses the other types of externalities as unimportant or, for production externalities on consumption, because they are trivially solved by government intervention. Scitovsky extends Viner's pecuniary externalities to investment.

James Meade (1952 EJ) published the first formal analysis of externalities, but in a way that is not readily recognizable today. He distinguishes two types of externalities, both positive, and both related to production only. He refers to the first type as unpaid factors, giving the example of the beekeeper's bees pollinating nearby apple blossom.[2] The second type, creation of atmosphere, is Marshall's knowledge spillovers.

Francis Bator (1958 QJE) put externalities in the form that is now commonly found in textbooks. A Pareto optimum requires that the marginal rate of substitution equals the output price ratio, the marginal rate of transformation the input price ratio, and the ratio of marginal productivities the output price ratio. Bator splits marginal social benefits and costs into its private and external parts. In an unregulated market, a consumer would only pay the marginal private benefits, disregarding the externality. A producer would only consider its marginal private costs, ignore the externality. The market would thus use price ratios that are not Pareto optimal. In Bator's words '"Price equal to MC" is saved, but wrong'. This immediately justifies a Pigou tax to correct the market price.

After this clear exposition, Bator then muddies the water by distinguishing three types of externalities. The first he calls ownership externalities, which cover the free services of positive externalities and the uncompensated damages of negative externalities. He also considers technical externalities, where prices and marginal costs are misaligned because of indivisibility or returns to scale. And he writes about public good externalities, where prices are wrong because consumption is non-rival or non-excludable. These latter two are market imperfections but perhaps best kept separate from externalities proper.

In the 11th edition of their textbook Environmental and Natural Resource Economics, Tom Tietenberg and Lynne Lewis write that "[a]n externality exists whenever the welfare of some agent, either a firm or household, depends not only on his or her activities, but also on the activities under the control of some other agent." They add that pecuniary externalities are no market failure. In the 4th edition of their textbook Natural Resource and Environmental Economics, Roger Perman, Yue Ma, Michael Common, David Maddison and James McGilvray, write that "[a]n external effect, or externality, is said to occur when the production or consumption decisions of one agent have an impact on the utility of profit of another agent in an unintended way, and when no compensation/payment is made by the generator of the impact to the affected party." Their addition of intention to the definition excludes pecuniary externalities, assuming, say, that companies intend to increase their market share at the expense of the competition. Their addition of compensation allows for externalities to be internalized so that the market imperfection disappears.

More succinctly, an externality is the unintended and uncompensated effect of one economic agent on a third party.

Intent: We burn coal to make electricity, not to emit carbon dioxide and soot. We hold bees to make honey, not to pollinate flowers.

Compensation: If pollination is remunerated or emissions taxed, the market failure is less pronounced; or may disappear altogether if the price is right.

Third party: The victim of pollution or the beneficiary of pollination do not engage in an economic transaction with the polluter or pollinator.

An internality is the unintended and uncompensated effect of an economic agent on herself.

A compensated externality is said to be internalized. In order to restore the efficiency of the market, that compensation should be at the Pigou tax.

The aim of much applied work is to estimate the value of the externality at the margin. Examples include the social cost of carbon.

Footnotes

  1. In his 1912 book, Wealth and Welfare, Pigou discusses a large number of examples of what he considers to be marker imperfections, but with little reference to externalities. Pigou's views on market imperfections were widely discussed; key contributions by Ellis & Fellner, Knight, Robinson, Sraffa, and Viner are found in a collection edited by Boulding and Stigler; see also Allyn Young's review.
  2. This may have been a good example in Meade's time. There is now a market for pollinator services, with beehives being trucked from farm to farm.