AN EXAMPLE OF AN EXTERNALITY

An Example of an Externality: Why Prices Fail To Represent the Opportunity Costs of the Resource and What Resolution a Tax Policy Can Bring To the Situation



Abstract

Externalities are one facet of the broader concept of “market failure,” which reflects the failure of the market outcomes always to coincide with the best interests of society, variously defined. Market failures may be distributional (the failure of markets to distribute income or wealth in the most desirable manner), allocational (the failure of the market to generate the efficient, or wealthmaximizing, result), or related to stability (the tendency of markets to generate cycles of inflation and unemployment). Externalities are an example of allocation failure—that is, the market process fails to generate the optimal amount of the spillover-generating activity. Positive externalities improve the welfare of an individual or a group without a cost. For example, if one's neighbor has an attractive garden or plays music that one enjoys, the receiving party derives benefits without incurring costs. Most positive externalities are relatively trivial. However, network externalities, which reflect the rising utility of systems such as telephone networks and the Internet, are important; the more people use a system, the greater the value it has to each user. However, negative externalities, which diminish the welfare of a person or group, are a different story. Examples of negative externalities include the reduction in real estate values created by the location nearby of an unwanted land use (e.g., a toxic waste plant). If a developer erects a high-rise that annihilates a homeowner's view, the affected party suffers a negative externality. More general cases involve the creation of air and water pollution, acid rain, noise pollution, and traffic congestion. Because the producers of negative externalities do not have an incentive to worry about the impacts of their actions on others, they generate social and market inefficiencies.

Introduction

Broadly speaking, externalities (also known as spillovers and neighborhood effects) refer to “uncompensated welfare impacts,” that is, actions and events that affect the welfare (positively or negatively) of one party or person by another without some type of remuneration. These arise when decision makers do not reap all of the rewards or bear all of the costs of their actions and can occur in both the production and consumption of goods and services.

Cowen, and Crampton (2003) mention that it is important that prices accurately reflect true scarcity conditions. Prices affect what type and amount of output firms choose to produce and what type and amount of inputs they will use. Prices also guide household decisions about what and how much to consume and what type and amount of labor to supply. If market prices do not accurately reflect scarcity conditions, firms and households will make production and consumption decisions that are socially inefficient (Cowen, and Crampton, 2003). This paper presents an example of an externality and why prices fail to represent the opportunity costs of the resource and what resolution a tax policy can bring to the situation in a concise ...