Encyclopaedic Dictionary of Strategic Management

Externalities

External costs (externalities for short) are often called social costs by economists. They
represent the total cost to society of any form of economic activity and may diverge from
private costs as reflected by the normal operation of the price mechanism. The production
and/or consumption of some products may give rise to some harmful or beneficial effects
that are borne by organizations or people not directly involved in such production or
consumption. Such side-effects are called externalities, spillovers, or external costs.

Early works on externalities include Sidgwick (1887) and Marshall (1890). A few years
later, Pigou (1920) considered the legal implications of externalities, and determined that
where externalities exist in the form of social costs, it is efficient for common law to be
applied so as to force the internalization of such externalities. Coase (1937), however,
disagreed with this view, claiming that some externalities are sometimes self-correcting,
and suggested that holding the party which created the externality liable under common
law is not necessarily efficient; instead, efficiency would be best achieved by balancing
costs and benefits, in which the role of causality was not decisive.

Types

Externalities can be categorized along a number of dimensions. The first is whether they
are negative or positive, according to whether the party which is affected by them
benefits or suffers. Second, externalities can be production- or consumption-based,
according to their source. Third, there are technological and pecuniary externalities.
Technological ones, the most common kind, simply relate to the indirect effect of a
consumption or production activity on the consumption or production of a third party.
Pecuniary externalities, on the other hand, work through the price system when prices
play additional roles other than equating demand and supply, such as when they transmit
information in an asymmetric information environment, or when they are affected by
some party, in which case this change also affects the welfare of other parties (e.g., one
industry's increasing consumption of petroleum affects another industry's welfare through
the higher petroleum prices).

Turning to examples of some types of externalities, external costs of production may

include oil spills, or the impact of extensive farming on wildlife. External costs of
consumption, on the other hand, may include the impact on non-smokers of smoking in
public places, or the effect of a neighbour’s decision to plant trees, the roots of which
may travel beyond the boundaries of the land on which they are planted and cause
damage to nearby properties.

External benefits of production, on the other hand, may come in the form of lower
training costs when a worker goes to work for another firm, improvements to regional
infrastructure, such as rail facilities, which may result from the needs of one firm but
subsequently be used by others, or the growth in peripheral supplier businesses, or
technology spillovers, which can often explain the clustering of similar firms in certain
geographic areas. Similarly, external benefits of consumption may include the existence

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of a well maintained garden, which increases the value of neighbouring properties, or the
installation of a new, quieter air conditioner.

Sources

Externalities arise primarily because of an incomplete definition of property rights in the

law. For example, they enable an industry which pollutes its environment through the use
of its assets to pass on the costs of cleaning up to the rest of the community.

Consequences

Externalities, which are identified by discrepancies between social and private costs,
typically lead to market failure. The most commonly encountered implication of
externalities is the misallocation of resources by the market mechanism; that is, allocative
inefficiency (see efficiency). This typically comes about in two distinct ways. First,
externalities may cause a deviation in the prices of goods from the marginal cost of
producing them and, second, externalities in the form of information spillovers may lead
firms to invest at sub-optimal levels, if they have reason to believe that they will be
unable to recoup the full cost of, say, some R&D investment.

Solutions

A number of solutions exist to reduce the impact of externalities. These include

prohibition, directives, or other regulation to eradicate or limit activities that generate
externalities. For example, cars may only be permitted to be driven for up to a set number
of days per week, or a requirement may be imposed for safety devices such as seat belts
to be installed, in order to reduce fatal accidents.

Another method, which is more suited to dealing with production externalities of non-
public goods, is forced internalization, whereby the party that generates the externality is
forced to deal with it itself, effectively eradicating the externality, which becomes part of
the producer's own set of constraints. A company that pollutes a river may be obliged, for
example, to acquire or merge with another company which makes heavy use of the
polluted water further downstream. A rather less radical method of forcing internalization
is by means of financial transactions such as (Pigovian) taxes (or subsidies, as
appropriate), or the marketing of externality generation rights; that is, the artificial
creation of a market for the externality.

Finally, as has been shown by Coase, it may be possible to reduce the harm caused by
externalities if the parties involved cooperate voluntarily. An example may be the
situation in which a city that suffers from airborne pollution pays the offending factory to
install improved equipment or relocate.

As far as a choice between the above methods is concerned, each is likely to have
different enforcement costs and a different probability of evasion, so the specific
circumstances will dictate the most appropriate one. In principle, it is more efficient not

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to eradicate the externality, but to limit it to the point at which the benefit from any
further marginal reduction equals the cost of any such reduction.

Bibliography

Arrow, K. (1969) “The organisation of economic activity: issues pertinent to the choice
of market vs. non-market allocation” in The analysis and evaluation of public
expenditure: the PPB system’ 91st US Congress, 1st Session, Joint Economic
Committee. Washington, DC, US Government Printing Office, pp. 47–64.
Coase, R. H. (1937) “The nature of the firm” Economica, 4 (November), 386–405
Coase, R. H. (1960) “The problem of social cost” Journal of Law and Economics, 3, 1–
44
de Clippel, G., Serrano, R. (2008),"Marginal Contributions and Externalities in the
Value", Econometrica, Vol. 76, 6. pp. 1413-1436
Gomes, A. (2005), "Multilateral contracting with externalities", Econometrica, Vol. 73,
4, pp. 1329-1350.
Marshall, A. (1890) Principles of economics, 8th ed., 1948. London and New York,
Macmillan
Pigou, A. C. (1920) The economics of welfare, London, Macmillan reprinted 1952
London, Macmillan/New York, St. Martin's Press
Seldon, Arthur, & F.G. Pennance (1965) Everyman’s Dictionary of Economics, London,
J M Dent & Sons
Shapley, L. & Shubik, M. (1969) “On the core of an economic system with externalities”
American Economic Review, 59, 687–9
Sidgwick, H. (1887) Principles of political economy, 2nd ed. London and New York,
Macmillan

Stephanos Avgeropoulos
rev John McGee

Abstract

The price mechanism ideally allocates resources to their most valued and efficient use.
But if the private cost of products diverges from the full costs then resources are
misapplied and there can be corresponding over or underproduction of the relevant
goods. The forces behind this are called external costs, externalities for short. There are
various types of externality with different consequences and differing solutions.

Keywords

External costs, social costs, market failure, efficiency, property rights

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