Cash Flow Analysis and Other Factors

In economics, an externality is a cost or benefit that is not transmitted through prices and is incurred by a party who was not involved as either a buyer or seller of the goods or services. The cost of an externality is a negative externality or external cost, while the benefit of an externality is a positive externality or external benefit.

Pollution is an example of a negative externality.

Relation to Prices

In the case of both negative and positive externalities, prices in a competitive market do not reflect the full costs or benefits of producing or consuming a product or service. Producers and consumers may neither bear all of the costs nor reap all of the benefits of the economic activity.

Over- and Under-Production

Standard economic theory states that any voluntary exchange benefits both parties involved in the trade. This is because buyers or sellers would not trade if either thought it was not beneficial.

However, an exchange can cause additional effects on third parties. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost. A voluntary exchange may reduce total economic benefit if external costs exist. The person affected by the negative externalities in the case of air pollution will see it as a lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses.

On the other hand, a positive externality would increase the utility of third parties at no cost to them. Since collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will be produced than would be optimal for society.

For example, manufacturing causes air pollution, which imposes costs on society, while public education benefits society. If external costs such as pollution exist, a competitive market will overproduce the good, as the producer does not consider the external costs when producing the good.

If there are external benefits, such as in areas of education, too little of the good would be produced by private markets as producers and buyers do not take into account the external benefits to others. Here, overall cost and benefit to society are defined as the sum of the economic benefits and costs for all parties involved.

"Free Rider" Problem

Positive externalities are often associated with the free rider problem. For example, vaccinated individuals reduce the risk of contracting the relevant disease for all others around them. Society may receive large health and welfare benefits at high levels of vaccination. Conversely, any one individual can refuse vaccination, still avoiding the disease by "free riding" on the costs borne by others.

Market Correction

The market-driven approach to correcting externalities is to "internalize" third-party costs and benefits, such as requiring polluters to repair any damage they cause. However, in many cases, internalizing costs or benefits is not feasible, especially if the true monetary values cannot be determined.