An externality is a situation in which the costs or benefits of producing or consuming a good or service are not reflected in its market price .
Seen in another way, externalities are side effects (good or bad) that occur when a person or a company performs an activity and does not assume all the costs of it, or all the benefits that could be reported. In this way, we can distinguish:
- Negative externality:It arises when not all the costs of a negative effect are assumed. We talk about negative externalities when, for example, a company pollutes its surroundings or when a person throws garbage into the street. In these two cases, a social cost is generated, since it is the whole society that suffers the consequences of its actions. And the market price does not collect this cost.
- Positive externality:It arises from a positive effect that is not reported as a benefit . An example of positive externality that we can mention is scientific research, from which society in general benefits. Another example would be the use of renewable energy, which benefits society because the person or company that uses them is not polluting. In these cases, market prices do not reflect the real benefits.
What is the solution to externalities?
Externalities are one of the market failures , and therefore they are one of the reasons why the State’s action in the economic activity of a country is justified.
To deal with negative externalities, the State can establish taxes on activities that negatively affect society or set quantitative limits to restrict them. The proposal of the president of France a few years ago that countries that emit more CO2 pay a tax, for example, is a way to make them pay for the negative externality of increasing the deterioration of the environment in the world.
Regarding positive externalities, the State can intervene to favor these activities through, for example, subsidies or grants.