Types of Externalities

Why This Matters

Externalities sit at the heart of why markets fail and why governments intervene in the economy. When you're tested on public economics, you're really being asked to demonstrate that you understand when private decisions diverge from social optimality—and externalities are the primary mechanism for that divergence. Every policy tool you'll encounter, from Pigouvian taxes to cap-and-trade systems to subsidies, exists because of externalities.

The key insight isn't just that externalities exist, but how they distort market outcomes. Negative externalities lead to overproduction because producers don't bear the full social cost; positive externalities lead to underproduction because producers can't capture the full social benefit. Don't just memorize the examples below—know what type of market failure each illustrates and what policy response it suggests.

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By Direction of Impact: Positive vs. Negative

The most fundamental classification asks: does the spillover help or harm third parties? This determines whether the market produces too much or too little of the good. When private marginal cost diverges from social marginal cost, we get inefficient quantities.

Positive Externalities

• Benefits spill over to third parties who aren't part of the transaction—the classic case of social benefits exceeding private benefits
• Market underproduction occurs because producers only respond to private incentives, not the full $MSB$ (marginal social benefit)
• Policy response typically involves subsidies or public provision to close the gap between private and socially optimal output

Negative Externalities

• Costs imposed on third parties who have no say in the transaction—social costs exceed private costs
• Market overproduction results because producers ignore external costs, producing where $PMC = PMB$ rather than $SMC = SMB$
• Policy tools include Pigouvian taxes, regulations, or tradable permits to internalize the external cost

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By Source: Production vs. Consumption

Where does the externality originate—in making the good or in using it? This distinction matters for targeting policy interventions effectively.

Production Externalities

• Arise during the manufacturing or creation process—the act of producing generates spillovers regardless of who consumes the final product
• Can be positive or negative: a beekeeper's pollination services benefit nearby farmers (positive), while factory emissions harm local residents (negative)
• Policy often targets producers directly through emission standards, production taxes, or technology mandates

Consumption Externalities

• Arise when individuals use a good or service—the spillover comes from the act of consumption itself
• Vaccination is the textbook positive example: your immunity protects others through herd immunity, generating benefits you can't capture
• Smoking in public spaces exemplifies negative consumption externalities—your consumption directly harms bystanders' health

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By Market Mechanism: Network vs. Pecuniary

Some externalities operate through direct physical or social spillovers, while others work through the price system. This distinction is crucial because only the former typically justify intervention.

Network Externalities

• Value increases as more users adopt—each new user benefits existing users, creating positive feedback loops
• Dominant in technology markets: social media platforms, operating systems, and payment networks all exhibit strong network effects
• Can create natural monopolies and lock-in, raising antitrust concerns even when the initial externality was positive

Pecuniary Externalities

• Operate through price changes rather than direct spillovers—a new coffee shop raises nearby rents, affecting other businesses
• Do not typically represent market failures because price signals are how markets should allocate resources
• Key distinction for exams: pecuniary externalities are informational, not allocative—they don't justify Pigouvian intervention

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By Scope: Local vs. Global

The geographic reach of an externality determines which level of government—or international body—must address it. Matching policy jurisdiction to externality scope is essential for effective intervention.

Local Externalities

• Effects confined to a specific community or region—traffic congestion, noise pollution, or a neighbor's unkempt yard
• Local governments are best positioned to respond because they have information about local conditions and affected parties
• Coasian bargaining may be feasible when the number of affected parties is small and transaction costs are low

Global Externalities

• Cross national borders, affecting the entire planet—climate change is the defining example of our era
• Require international cooperation because no single nation bears the full cost or captures the full benefit of action
• Free-rider problems are severe: each country prefers others to bear the cost of abatement while enjoying the global benefits

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By Time Horizon: Intertemporal Externalities

When current actions affect future generations, standard market mechanisms fail completely—future people can't participate in today's markets.

Intertemporal Externalities

• Current decisions impose costs or benefits on future generations who have no voice in present transactions
• Resource depletion and environmental degradation are classic examples—we extract benefits today while future generations bear the costs
• Discounting creates policy challenges: how much weight should we give to welfare 50 or 100 years from now? The choice of discount rate is both technical and ethical

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By Origin: Technological Externalities

Innovation creates spillovers that extend far beyond the innovator—both beneficial and disruptive.

Technological Externalities

• Knowledge spillovers from R&D benefit firms and society beyond the innovating company—this is why we subsidize research
• Positive spillovers include public health improvements from medical breakthroughs that save lives far beyond paying customers
• Negative spillovers include labor market disruption from automation, where productivity gains may come with displacement costs

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Quick Reference Table

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Self-Check Questions

1. Both vaccination and education generate positive externalities—what do they share in terms of market outcome, and how do their mechanisms for creating spillovers differ?

2. A factory dumps waste into a river, harming downstream fisheries. Classify this externality by direction, source, and scope. What policy tools would be appropriate?

3. Why do pecuniary externalities not typically justify government intervention, while network externalities often do? What's the key economic distinction?

4. Compare climate change and traffic congestion as externalities. Both are negative, but why does one require international cooperation while the other can be addressed locally?

5. An FRQ asks you to explain why markets underproduce R&D. Which type(s) of externality should you discuss, and how would you illustrate the welfare loss graphically?