Overview

The Free Market is great at setting prices, but it has a blind spot. It ignores “side effects.” If a factory pollutes the air, the factory owner gets rich, but the neighbors get sick. The sickness is a cost that isn’t included in the price of the product. That is an Externality.

Core Idea

The core idea is Mispricing. The price tag is wrong.

  • Negative Externality: The product is too cheap because the seller isn’t paying for the damage (Pollution).
  • Positive Externality: The product is too expensive because the buyer isn’t paid for the benefit (Vaccines).

Formal Definition

A cost or benefit caused by a producer that is not financially incurred or received by that producer. Pigovian Tax: A tax designed to fix this. Tax the pollution until the price reflects the true cost.

Intuition

  • The Party: Your neighbor throws a loud party. He enjoys it (Benefit). You can’t sleep (Cost). He is imposing a “Negative Externality” on you.
  • The Garden: Your neighbor plants beautiful flowers. He enjoys them. You also enjoy looking at them (Benefit). He is providing a “Positive Externality.”

Examples

  • Carbon Tax: Burning gas causes climate change (Externality). A Carbon Tax makes gas more expensive, forcing drivers to pay for the environmental damage.
  • Education: An educated person is less likely to commit crime and more likely to invent things. This benefits everyone, not just the student. That’s why the government subsidizes schools (Positive Externality).
  • Smoking: Second-hand smoke harms others. High taxes on cigarettes are meant to offset this cost to the healthcare system.

Common Misconceptions

  • Pollution should be zero: Economically, the optimal amount of pollution is not zero. It’s the point where the cost of cleaning it up equals the damage it causes. (Zero pollution means zero factories).
  • Tragedy of the Commons: When everyone acts in their own self-interest and destroys a shared resource (Overfishing).
  • Coase Theorem: If property rights are clear and transaction costs are low, people can bargain to solve externalities without government. (You pay your neighbor $50 to turn down the music).

Applications

  • Cap and Trade: A system where the government sets a limit on pollution and lets companies trade permits.

Criticism / Limitations

  • Valuation: How much is a polar bear worth? It’s hard to put a price tag on nature, so it’s hard to set the right tax.

Further Reading

  • Pigou, Arthur. The Economics of Welfare.
  • Hardin, Garrett. The Tragedy of the Commons.