Externality

Economist Arthur Pigou introduced the concept of externality in 1918 publication of ‘The Economics of Welfare’. As per economic theory, an externality is said to have arisen when an economic agent via his actions imposes either a cost or a benefit on other economic agents. In simple words, an externality is the consequence of an action by an economic agent, which is being realized by other economic agents(s) who are ‘unrelated third party’. Externalities are termed as positive or negative depending upon how they affect these unrelated third party. Effect of skilled labor force on an organization’s productivity is an example of positive externality. While the effects of air pollution (from a factory) in its neighbourhood is an example of a negative externality. Herein comes the notion of private cost (private benefit) and social cost (social benefit). Private cost refers to that cost, which is being borne by that individual entity, which undertakes an activity. Private benefit refers to that benefit, which accrues completely to an individual economic entity, undertaking an activity. Social costs comprise private costs as well as sum total of all costs borne by all other entities, due to activity. Similarly, social benefit takes account of benefits accruing to all entities in society due to activity. Externality arises when there occurs a divergence between social and private costs (benefits) of an activity. Concept of externality has interesting connotations in diverse fields of the modern-day world starting from international trade to the realm of environmental taxes.

Externality Remedies

Some ways of regulating externality effects are described below.

• Government can either regulate negative externality causing private actions or can alternatively itself provide positive externality causing services
• Government can tax negative externality causing activities. This tax amount can be such selected that it is equal to the difference between concerned private cost and social cost. Similarly, government can subsidize positive externality producing activities. This subsidy could be such set that it equates the difference between private benefits and social benefits. Thus government can internalize an externality. Now private decisions by economic agents in a competitive market would foster socially optimum outcomes.

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