Externalities, where the effects of one person’s economic activity on others are not reflected in market prices, lead to inefficient allocation of resources. To address this, governments use regulations and subsidies to reduce negative externalities and encourage positive externalities.
In everyday life, the economic activities of one person affect the economic activities of others, and in most cases, these effects are reflected in market prices. However, there are situations where one person’s economic activity unintentionally benefits or harms another, and this is not reflected in the price. For example, people driving cars emit exhaust on the streets, and factories producing goods can create odors or noise. These activities affect third parties, even if unintentionally, but sometimes they are not paid for or compensated. In economics, these are called “externalities”. The term externalities comes from the idea that the benefits or harms to third parties are “outside the market” because they cannot be bought or sold in the marketplace. They are characterized by the fact that they are not priced and are not naturally reflected in market prices.
Externalities can be negative, as in the examples above, but they can also be positive. For example, if you sweep the sidewalk in front of your house every day, your neighbors will enjoy walking down a clean street. If a new flower shop sets up a display of fragrant flowers every day, people walking down the street can enjoy the scent without having to pay for it. Externalities that provide unintended benefits to others are called positive externalities. On the other hand, externalities that cause unintended harm to others are called negative externalities.
Positive and negative externalities interfere with the workings of market forces. This is because the impact of one economic entity on another is not adequately compensated through markets or prices. For example, private car drivers emit fumes, but they don’t compensate passersby along the road for the damage they cause. Similarly, a factory that produces noise or odors is not compensated by the people who live nearby. Neither do neighbors compensate a florist who makes people feel good with the scent of flowers. In these situations, negative externalities are produced more than is socially desirable because they are not paid for, and positive externalities are produced less than is socially desirable because they are not paid for.
Government intervention is needed to address this inefficient allocation of resources. Governments use regulatory methods such as banning, quarantining, setting standards, and taxing negative externalities. For example, they may limit the amount of pollutants a company is allowed to emit or impose an environmental pollution tax on companies that emit pollutants. In this case, firms will try to reduce the amount of pollution they emit because it increases their production costs. Conversely, if a positive externality is generated, the government encourages this activity through subsidies or tax breaks. For example, the government may subsidize or provide tax breaks for activities that greatly benefit society, such as reforestation. These policies play an important role in promoting the expansion of positive externalities.
Additionally, externalities are an important concept to deepen our understanding of how an individual’s economic activity affects the community as a whole. For a society to remain healthy, individual economic actors must be able to take into account the impact of their activities on others and the community. Therefore, effectively managing externalities is an important public policy challenge, not only to ensure the efficient allocation of resources, but also to ensure the sustainability of the community. Appropriate government intervention and regulation is essential to promote the welfare of society as a whole, which can benefit all economic actors in the long run.
