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INTRODUCTION When marketing the claim that free, unregulated market maximizes the amount of value created for

a society, economists either implicitly or explicitly assumes that the action on choices of products consumers in a market don’t have any spillover effects on to third parties who aren’t directly involved in the market as a producer or a consumer. When this assumption is taken away, is no longer has to be the case that unregulated market are value marketing so it’s important to understand these spillover effect and their impact on economic value. Economists call effects on those not involved in a market externalities, and externalities vary among two dimensions. First, externalities can be either negative or positive. Not surprisingly, negative externalities impose spillover costs or otherwise uninvolved parties, and positive externalities confer spillover benefit on otherwise uninvolved parties.( when analyzing externalities, it’s helpful to keep in mind that costs are just negative benefits and benefits are negative costs). Second, externalities can be either on production or consumption. In the case on externality on production, the spillover effect occur when a product is physically produced. In the case of an externality on consumption, the spillover effect occur

when a product is consumed, combining these two dimensions gives four possibilities. Therefore , in this chapter we will try to give a brief description on externality. MEANING OF EXTERNALITY Here are some of the meanings of externality  Externalities are costs ( negative externalities) or benefits ( positive externalities ), which are not reflected in free market prices. Externalities are sometimes referred to as 'by products ' , 'spillover effects ' for example, as the generator of the externality , either producers or consumers, or both, impose costs or benefits on others who are not responsible for initiating the effect.  When the activity of one entity ( a person or a firm ) directly affects the welfare of another id a way that is outside the market mechanism, that effect is called an externality . This is because one entity directly affect the welfare of another entity that is "external" to it . unlike effect that are transmitted through market price , externalities adversely affect economic efficiently.

 An externality, or transaction spillover, is a cost or benefit that is not transmitted through prices.  It is incurred by a party who was not involved as either a buyer or seller of the good/services causing the cost or benefit .  The cost of externalities is a negative externality or external cost , while the benefit of externalities is positive externality or , external benefit . In the case of both negative and positive externalities, prices in a competitive market do not reflect the full cost or benefits of producing or consuming a product or services . producer and consumers may neither bear all of the cost nor reap all of the benefit of the economic activity ., and too much or too little of the good will produced or consumed in terms of overall cost and benefit to society . CHARACTERISTICS OF EXTERNALITY The key feature of an externality is it is initiated and experienced, not through the operation of the price system, but outside the market. Here are some of key feature of an externality. 1. They can produced by consumer as well as firms. This is to mean that, just think of person who smoke a cigar in a crowded room, lowering others' welfare by using up the common reasons i:e fresh air. 2. Externalities are reciprocal in nature. 3. Externalities can be positive. Suppose that in response to a terrorist threat you were to get yourself vaccinated against smallpox. You would incur some cost the price of

the vaccination , the associated discomfort , and the slight risk that it would induce a case of the disease. There would be a benefit to you in terms of a reduced probability of being stricken by the disease in the event of a bioterrorism attack. 4. Public good can be viewed as a special kings of externality. This is, specifically, when an individual creates a positive externality with full effect felt by every person in the economy, the externality is a pure public good. For example, Suppose that someone installed a device for electrocounting Mosquitoes. If he/she killed the community's of Mosquitoes, then, he/she has in effect created a pure public good . If only a

few neighbors are affected , then it is an externality. Although , positive externalities and public good are quite similar from a formal point of view.

I .THE MAIN TYPES OF EXTERNALITY A. Negative externality (also called "external cost " or "external diseconomy " ) Is an action of a product on consumers that imposes a negative side effect on a third party: it is" Social Cost " . M any negative externalities are related to the environmental Consequences of production and use. The article on environmental economics also addresses externalities and how they may be addressed in the context of environmental issues.

EXAMPELS OF NEGATIVE EXTERNALITY  Air pollution from burning fossil fuels causes damages to crops, buildings and public health.  Anthropogenic climate change is attributed to greenhouse gas emission from burning oil, gas, and coal.  Water pollution by industries that adds poison to the water, which harm plants, animals, and humans.  Noise pollution is mentally and psychologically disruptive.  Systematic risk describes the risk to the overall economy arising from the risks which the banking system takes. A condition of moral hazard can occur in the absence of well designed banking regulation.  The harvesting by one fishing company in the ocean depletes the stock of a variable fish for the other companies and overfishing may be the result.  When car owners use roads, they impose congestion costs and higher accident risks on all other users.  Consumption by one consumer causes prices to rise and therefore makes other consumer worse off, perhaps by reducing their consumption. The effect sometimes called "pecuniary externalities " and are distinguished from "real externalities " or "technological externalities ". pecuniary

externalities appear to be externalities, but occur within the mechanism and are not a source of market failure or inefficiency.

B. positive externality or , external benefit
Such kinds of externality exists when an individual or firms marking a decision doesn’t receive the full benefit of the decision. The benefit to the individual or firms is less than the benefit to the society. Thus when a positive externality exists in unregulated market, the marginal

benefit curve ( the demand curve ) of the individual making the decision is less than the marginal benefit curve to the society with positive externalities, less than produced and consumed than the

socially optimal level. When positive externality exists in unregulated market, consumers pay a lower price and consume less quantity than the society efficient outcome.

II. OTHER TYPES OF EXTERNALITY Pollution is an example of an externality which is commonly cited, but it is important to establish at this stage that there are various types of externalities and that they can be classified in different ways: they arises from acts of consumption or production, and can thus be

production, consumption, or mixed externalities , and as previously mentioned

they can be experienced as external costs( negative externalities ) or as external benefits ( positive externalities ). According to such classification we can have four different varieties of externality: A. A production externality: initiated in production and received in production:  Example of negative externalities: The discharge of radioactive waste from a nuclear power station enters the food chain makes local meats unsalable.  Example of positive externalities: A firm offers training to its workforce which increase their skills: other firms benefit when the workers change a job. B. A mixed externality: initiated in production, but received in consumption:

 Example of negative externalities: A firm sales sweets to children which causes tooth decay, too thatched and extreme discomfort.  Example of positive externalities: A DIY store landscape and adjacent at much of wasteland enhancing the attraction of the area for all who pass by. C. A consumption externality: initiated in consumption and received in

consumption:  Example of negative externalities: A minority of rowdy students in class talk among themselves, thus preventing the majority of well behaved students from learning. Or, a person smoking a pipe at a football match causes the person sitting behind to passively smoke.  Example of positive externalities: A person get vaccinated against a contagious disease and prevent it spreading to other people. D. A mixed externality: initiated in consumption, but received in production:  Example of negative externalities: People drink excessive amount of alcohol which impairs their health and thus their efficiency at work.  Example of positive externalities: A firm’s employees spend their lunch breaks at a fitness center: their health is improved which enhance their efficiency at work. E. POSITIONAL EXTERNALITY Positional externality refers to a special type of externality that depends on the relative ranking of actors in a situation. Because every actor is attempting to "one up " other actors, the consequences are unintended and economically inefficient.


 The buying of jewelry as a gift for another person, e.g. a spouse. For husband A to show that he values wife A more than husband B values wife B, husband A must buy more expensive jewelry than husband B. F .INFRAMARGINAL EXTERNALITY Inframarginal externalities are externalities in which there is no benefit or loss to the marginal consumer. In other words, people neither gain or loss anything at the margin, but benefits and costs do exist for those consumers within the given inframarginal range. G .TECHNOLOGICAL EXTERNALITY Technological externalities directly affect a firms production and therefore, indirectly influences an individual's consumption. SUPPLY AND DEMAND DIAGRAM The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be valued in terms of money. An extra supply or demand curve is added, as in the diagram below. One of the curves the positive cost that consumers pay as individuals for additional quantities of goods, which in competitive markets, is the marginal private cost. The other curve is the true cost that society as a whole pays production and consumption of increased production of good, or the marginal social cost. Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to the society as a whole, while the normal demand curve reflect the benefit to consumers as individuals and is reflected as effective demand in the market. EXTERNAL COSTS The graph below shows the effect of a negative externality. For example, the steel industry is assumed to be selling in a competitive market- before pollution –control laws were imposed and enforced. The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i:e, the cost air pollution and water pollution. This is represented by the vertical distance between the two supply

curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit . If the consumer only take into account their own private cost, they will end up at price Pp and quantity QP, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, that is that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result is that a free market is inefficient since at the quantity QP, the social benefit is less than the social cost, so society as a whole would be better off if the goods between QP and QS had not been produced. The problem is that people are buying and consuming too much steel.

buying too few vaccinations. The issue of external benefits is related to that of public goods where it is difficult if not impossible to exclude people from benefits. The production of public good has beneficial externalities for all, or almost all, of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefit and costs. This also implies that vaccination is not something solved by

competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government do this, the good is called a merit good.

POSSIBLE SOLUSTIONS There are at least four general types of solutions to the problem of externalities. A. CRIMIMINALIZITION: As with prostitution in some countries, drugs, commercial fraud, and many types of environmental and public health laws. B. CIVIC TORT LAW: For example, class action by smokers,

various product liability suits. C. GOVERNMENT PROVISION: As with lighthouses, education, national defense. D. PIGOVIAN TAXES OR SUBSIDIES : economic injustices or imbalance. A Pigovian tax is imposed that is equal in value to the negative externality. The result is that the market outcome would be Intended to redress

reduced to the efficient amount. A side effect is that revenue is raised for the government, reducing the amount of distortionary taxes that the government must impose elsewhere. Economisits prefer pigovian taxes and subsidies as being the least intrusive and most efficient method to resolve externalities. Government justify the use of pigovian taxes saying that these taxes help the market reach an efficient outcome because this tax bridges the gap between marginal social costs and marginal private costs. Some counter argument against pigovian taxes say that the tax dose not account for all the transfers and regulations involved with an externality. In other words, the tax only considers the amount of externality produced. Another argument against the tax is: it does not take private property into consideration . Under the pigovian tax system, one firm for example, can be taxed more than another firm, when in reality, the latter firm is producing greater amounts of the negative externality. However, the most common type of solution is tacit agreement through the political process. Government are elected to represent citizens and to strike political

compromises between various interests. Normal government pass laws and regulations to address pollution and other types of environmental harm. These laws and regulations can take the form of "command and control "regulation (such as setting standards, targets, or process requirements) ,or environmental pricing reform ( such as ecotaxes or other pigovian taxes, tradable pollution

permits or the creation of market for ecological services ). The second type of resolution is a purely private agreement between the parties involved. Government intervention may not always be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically run communities can agree to deal with these costs and benefits in an amicable way. Externalities can sometimes be resolved by agreement between the

parties involved. This resolution may even come about because of the threat of government action. Ronald Coase argued that if all parties involved can easily organize payments so as to pay each other for their actions, then an efficient outcome can be reached without government intervention. Some take this argument further, and make the political claim that government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This results, often known as the Coase Theorem, requires that    Property rights be well defined People act rationally Transaction costs be minimal

If all of these conditions apply, the private parties can bargain to solve the problem of externalities. This theorem would not apply to the steel industry cases discussed above. For example, with a steel factory tht trespasses on the lungs of a large number of individual with pollution, it is difficult if not impossible for any one person to negotiate with the producer, and there are large transaction costs. Hence the most common approach may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable" ) while paying for the regulation and enforcement with taxes. The case of the vaccination would also not satisfy the requirements of the Coase Theorem. Since the potential external beneficiaries of vaccination are the people themselves, the people would have to self-organize to pay each other to be vaccinated. But such an organization that involves the entire populace would be indistinguishable from government action.

METHODS OF REDUCING EXTERNALITIES When it comes to correcting the market failure of negative externalities, government has several options. The most interventional approach may involve placing strict limits on the amount of a pollutant firms are allowed to emit and fining them for exceeding this limit, taxing firms the pollute in order to increase their costs and decrease market supply, reducing output and increasing price closer to a socially optimal level, or simply banning the production and consumption of goods whose existence place excessive spillover costs on society. Such interventional approaches to externality reduction tend to require a complex bureaucracy to administer, monitor, execute and enforce. The government may not be able to determine the appropriate level of a tax on polluter if it cannot determine the exact level of the externalized costs placed on society: the government cannot always check up on every producer in the economy to determine just exactly how much pollution each factory's producing, and then levying fine on excessive polluter again raises the question of how high should a penalty be? Because of the complexity involved in the interventional approaches above, economists have recently promoted and the worlds' government have begun adopting a market based approaches to reducing negative externalities, involving the creation of a whole new market: one in which the right to pollute is bought and sold by firms. This may sound crazy at first, but here is a basic summary of how these market work:  A government or international agency decides on the acceptable amount of pollution in a particular region and issues permits that firms can purchase giving them the right to pollute. Each permits will allow a certain amount of pollution. The total supply of permits is perfectly inelastic since it is decided by the government agency. The demand for pollution permits is downward sloping. At high price, firms will either stop polluting or pollute less by acquiring pollution abatement equipment, which is more attractive when the right are more expensive. If the "costs of pollution" is cheap, then firms will chose to permits rather than acquiring expensive abatement equipment or upgrading to "greener" technology. In the market for pollution permits, the "price to pollute" will be determined by the downward sloping demand among firms for pollution permits and the perfectly inelastic supply of permits determined by the number issued by the government. If the price of permits is too low to make firms bear the full environmental and social costs of their production, the government can reduce the supply of thus increase the

price and decrease the quantity of pollution permits demand, reducing the negative externalities of pollution as firms will shift to greener production techniques. There are several advantage to this system over government control: It reduces society’s costs because pollution rights can be bought and sold. Some firms will find it cheaper to by the rights than to acquire abatement equipment: other firms can sell their right because they may able to reduce pollution at a lower cost. The incentive for all firms is to reduce their own pollution and sell the permits they no longer need, adding to the profits of "greener firms"

Conservation groups and individuals can by permits as well as producers. If conservation or individuals wish to make it more expensive for firms to pollute, they can by permits and hold them. This advise up the price of remaining rights, further encouraging pollute to reduce emission.

The revenue from the sale of pollution rights could be used to improve the environment or subsidies more environmentally friendly methods of productions.

The rising cost of pollution rights should lead to improved pollution-control techniques. SUMMARY An externality occurs when the activity of one person affects another person outside the market mechanism. Externalities may generally be traced to the absence of enforceable property rights. Externalities causes market prices to diverge from social cost, bringing about on inefficient allocation of resources. The Coase theorem indicates that private parties may bargain towards to the efficient output if property rights are established. However, bargaining costs must be low and the source of the externality easily identified. A pigovian tax is a tax levied on pollution in an amount equal to the marginal social demand an efficient level. Such as tax given the producer a private incentive to pollute the efficient amount.

A subsidies for pollution not produced can induce producers to pollute at the efficient level. However, subsidies can lead to too much production, are administratively difficult, and are regarded by some as ethically unappealing. Positive externalities generally lead to under provision of an activity. A subsides can correct the problem, but care must be taken to avoid wasteful subsides.

TITLE PAGE INTRODUCTION ----------------------------------------------------------------------1 MEANING OF EXTERNALITY-----------------------------------------------------1 CHARATERISTICS OF EXTERNALITY------------------------------------------2 THE MAIN TYPES OF EXTERNALITY-------------------------------------------2 4.1 NEGATIVE EXTERNALITY ---------------------------------------------------2 4.2 POSITIVE EXTERNALITY -----------------------------------------------------3 5. OTHER TYPES OF EXTERNALITY -----------------------------------------------3 5.1 A PRODUCTION EXTERNALITY --------------------------------------------4 5.2 A MIXED EXTERNALITY ------------------------------------------------------4 5.3 A CONSUMPTION EXTERNALITY ------------------------------------------4 5.4 A MIXED EXTERNALITY ------------------------------------------------------4 5.5 POSITIONAL EXTERNALITY -------------------------------------------------4 5.6 INFRA MARGINAL EXTERNALITY -----------------------------------------5 5.7 TECHNOLOGICAL EXTERNALITY ----------------------------------------5 1. 2. 3. 4.

6. SUPPLY AND DEMAND DIAGRAM ----------------------------------------------5 7. POSSIBLE SOIUTION ----------------------------------------------------------------7 7.1 CRIMINALIZATION -------------------------------------------------------------7 7.2 CIVIC TORT LAW ----------------------------------------------------------------7 7.3 GOVERNMENT PROVISION --------------------------------------------------7 7.4 PIGOVIAN TAXES OR SUBSIDES -------------------------------------------7 8. METHODS OF REDUCING EXTERNALITIES ----------------------------------9 9. SUMMARY ----------------------------------------------------------------------------10 10. REFERENCES -------------------------------------------------------------------------11

REFERENCES  Harvey , Rosen, Public Finance, 7th ed. MeGraw Hill Inc. , 1995  Externality – Wikipedia, the free encyclopedia.