Externalities: basics

In short: Externalities refer to the effects of economic activities on uninvolved third parties that aren’t compensated through the market price. They’re among the main reasons for government intervention in free markets.

In more detail: A distinction is made between negative externalities, which harm third parties, and positive externalities, which benefit them.

In detail

• Negative externalities: Pollution from a factory harms residents and the environment without the company bearing these costs in its price.
• Positive externalities: A person’s education benefits not only themselves but also society as a whole through higher productivity and lower crime.
• Market failure: Without government intervention, markets produce too much of goods with negative externalities and too little of goods with positive externalities.
• Pigouvian tax: A targeted tax on harmful activities, such as CO2 emissions, aims to incorporate the true social costs into the market price.
• Subsidies: With positive externalities, government grants, for example for education or research, can raise production to a socially optimal level.
• Cap-and-trade systems: Systems like emissions trading set an upper limit for harmful activities and let the price emerge through supply and demand.
• Limits of solutions: Precisely valuing external costs and benefits is often difficult in practice, which complicates designing effective policy measures (angebot-und-nachfrage, co2-fussabdruck-im-alltag).