Externalities

What are externalities? For answering in an elevator

We call externalities the impact that a given economic action generates on third parties not directly involved in that action. They can be both positive and negative.

What are externalities? With a little more time

The main interest of any company lies in maximizing profit. That is, to achieve the greatest possible difference between its revenues and its costs. If we think of it in unit terms, this would be the difference between the price at which a good is sold and the unit cost of producing it.

Thus, for example, the cost of producing a package of cookies will be given by the value of its packaging, the ingredients used to bake it, the plant rent and the hiring of labor, among others, while the selling price reflects the unit revenue of the cookie company. On a broader scale, one could think that the value added of a society as a whole is constituted precisely by the sum of the differences between the income and the expenses of all the productive units. Now, what happens if in the industrial process of cookie production the company is generating severe environmental damage? This is also a related cost, but it should not be absorbed directly by the producing company, but by society as a whole.

Good externalities

Actions related to education and health are often taken as typical cases of positive externalities. For example, let us consider the vaccination of a population. When a person is vaccinated, he is not only protecting himself from the possibility of contracting a virus, but also reducing the transmission and contagion of that virus for the whole society... even for those who are not vaccinated!

The same can be thought in relation to schooling: a more educated society generates better welfare indexes as a result of greater respect, greater creativity, greater social ties.

Both in the case of vaccination and in the case of education, the social benefits (including indirect ones) are significantly greater than the direct ones, since part of the benefit is not received by the individual who takes it, but by other people who were not directly involved in the action.

Bad externalities

In cases of negative externalities, the total costs (including indirect costs such as social costs) are greater than the private costs of production. Typical examples are environmental pollution, such as when a company produces polluting emissions that it does not take into account as a private cost of production. Another case could be an open-air concert, whose noise could affect nearby houses, but this is a direct cost for the producer. can you think of others?

What to do?

One of the roles of public policy in this regard is to encourage those goods with positive externalities, while discouraging the production and/or consumption of those with negative externalities. A great tool for this lies in taxation: levying a tax on polluting activities (so that the social costs are absorbed by the producing company) and subsidizing education and vaccination, so that the individual benefits absorb part of the social benefit of the positive externalities.