Which one of the following is a means of coping with a negative externality?

In economics, an externality is a side-effect, either positive or negative, of production or consumption. It occurs when the impact of the activity spills over onto third parties, not otherwise engaged in the activity.

Negative Externalities

One common illustration of a negative externality is that of environmental pollution. Suppose I am the owner of a factory that makes and sells widgets, and I end up polluting a nearby stream with the waste products of my widget-making process. The impact of this pollution is neither felt by me nor by my customers, however, it is a negative externality for the neighbors of my factory, who suffer the consequences of the widget-fouled stream.

Externalities are an example of an imbalance in the free market, because the cost of a negative externality is paid by someone outside of the economic activity and not reflected in the price of production. Government often mitigates the imbalance represented by a negative externality by taxing the producer. By placing taxes upon factories that don't meet certain emission standards, government can incent factories to invest in necessary upgrades to their physical capital so that they meet those emission standards.

Positive Externalities

Externalities can be positive as well. Public education is one example of a positive externality. The positive effects are felt nationwide - education provides for a better informed citizenry, decreases unemployment, and increases national competitiveness in the global marketplace.

Another example of a positive externality would be that upon a farmer living next door to a beekeeper. The beekeeper's bees will naturally help pollinate the farmer's crops, providing the farmer with an unintentional benefit. Though the benefit is positive, this is also viewed by economists as an imbalance in the market because the benefit is not accounted for by the parties involved in the economic transaction. Government can address this by subsidizing and thus rewarding the producer for the positive externality, as is sometimes the case with public education.

Sometimes an activity can produce both positive and negative externalities. For instance, if a nightclub opens up in an otherwise sleepy town, that could generate positive externalities such as greater revenues for the surrounding businesses. However, that same nightclub could also bring noise pollution and contribute to increased criminal activity, driving renters in the area away.

Whether an externality is positive or negative, it is the government's role in a market economy to enact policies to deal with them, whether by taxation in the case of a negative externality or by subsidy in the case of a positive externality.

Do you recall that last time you left your dirty clothes in your school locker or tossed your banana peel out and didn't quite hit the bin target? Guess what? You contributed to the world of externalities without even realizing it! The cost of these actions was tiny to you, but your neighboring locker student suffered from a horrible smell each time they had to use their locker. A teacher might have just stepped on that banana peel and almost fell over. Feeling guilty? Then dive into this article to learn everything about externalities and how correcting externalities improves the well-being of the whole society! Keep reading to learn more about correcting positive and negative externalities and some examples to help you understand it better.

Correcting for Externalities Definition

What is the definition of externalities? In economics, externalities are defined as unintended consequences of a transaction or an activity. These spillover effects indirectly benefit or harm a third party. The third party, in this case, is not involved in a transaction or activity that caused the externality in the first place.

Air pollution is something all of us are equally affected by. Imagine a student who doesn't even drive a car and cycles or walks to school every day. They may not even be a direct cause of air pollution compared to someone who travels by car everywhere they go.

Externalities are unintended consequences of a transaction or an activity that indirectly benefits or harms a third party.

Externalities and market failure

Externalities are one of the sources of market failures alongside other factors. These other factors are inadequate information and competition, resource immobility, and public goods.

Learn more on this topic in our article - Market Failures!

But how exactly do externalities contribute to market failure? Externalities cause market failure because the market prices do not reflect the indirect costs or benefits to the whole society. This results in less efficient economic outcomes as producers and consumers choose sub-optimal decisions from a societal point of view. This distortion in decision-making is what ultimately results in market failures. The free market will produce too much of a negative and too little of a positive externality.

The factory polluting the air on the outskirts of the city does not compensate you for having a lower air quality you breathe in daily.

The factory that opened on the city's outskirts generated jobs and income for the families of the newly employed workers. The factory owner does not share the additional profit generated from this enterprise directly with you.

Correcting Externalities: Types of Externalities

There are two types of externalities. But before we get into this, let's recall what externalities are.Externalities are unintended consequences of a transaction or an activity that indirectly benefits or harms a third party. But these consequences can be positive as well as harmful.If positive indirect effects occur from a transaction or an activity, it is called a positive externality. A negative externality arises if adverse indirect effects arise from a transaction or an action.

Positive and negative externalities examples

Let's go over some examples of positive and negative externalities.

Imagine your neighbor regularly mows their lawn, plants flowers, and paints their fence and house with fresh paint every year. Doing so benefits the whole neighborhood as it makes the entire area look pretty.

Imagine your neighbor leaves trash outside their house, doesn't plant grass and flowers, doesn't sweep their territory, and doesn't paint their home and the fence. They indirectly cause adverse effects to the whole neighborhood as their derelict house with junk lying around looks like an eye sore.

An electric power plant near a local river can enjoy cost savings from easy access to large amounts of water. These cost savings reduce the unit price of energy for consumers in the local region, thereby improving its affordability.

The same electric power plant can dispose of the waste in the river. The wastewater pollution results in the fish population declining in the area. Local fishermen now have fewer fish and are struggling to earn income to support their families.

Positive externalities are indirect positive effects of a transaction.

Negative externalities are indirect negative effects of a transaction.

Government Intervention to Correct Externalities

Government intervention is often required to correct externalities. Think of the pollution externality example of a power plant polluting a local river. Unless the government intervenes, the plant will continue polluting because it generates the most profits for them. Local residents living away from the river and not impacted by pollution would support the lower energy cost that the power plant provides. This would encourage the plant to continue its activities in the same way.What possible solutions can the government implement to tackle negative and positive externalities? Let's go over each of them in turn!

Correcting negative externalities

How can the government correct negative externalities? As there is usually too much of a negative externality, the government needs to try and reduce this amount. It can do so by imposing a tax on a firm that produces a negative externality.Consider Figure 1 below.

Figure 1. Optimal tax to correct a negative externality, StudySmarter Originals

Figure 1 above shows how the government can correct a negative externality by imposing a tax. The initial equilibrium is at the intersection of the demand curve (D) and the supply curve (S0). The tax increases production costs for a firm, shifting its supply curve to Stax. The equilibrium shifts from (P0, Q0) to (Pc, Qtax). This eliminates the inefficiency or a deadweight loss depicted by the red-shaded triangle. The government collects a tax revenue equal to the purple-shaded area.If the intervention is optimal, then the tax per unit will equal the cost of the negative externality per unit. The new price will reflect this particular good's actual cost to society. The efficient quantity will then be produced and consumed.

Measuring the exact cost to society that a negative externality causes is complex. That is why the resulting outcome of government intervention often brings the market towards the optimum outcome but does not precisely reach it.

Correcting positive externalities

How can the government correct positive externalities? As there is usually too little of a positive externality, the government needs to try and increase this amount. It can do so by providing a subsidy to a firm whose production exhibits a positive externality.Consider Figure 2 below.

Figure 2. Optimal subsidy to correct a positive externality, StudySmarter Originals

Figure 2 above shows how the government can correct a positive externality by providing a subsidy. The initial equilibrium is at the intersection of the demand curve (D0) and the supply curve (S). The subsidy allows the consumers to demand more at each price level, shifting the demand curve from D0 to Dsubsidy. The equilibrium shifts from (P0, Q0) to (Pp, Qsubsidy). This eradicates the inefficiency or a deadweight loss represented by the red-shaded triangle. The government incurs a subsidy expense equal to the yellow-shaded area.

If the intervention is optimal, the subsidy per unit will equalize the benefit of the positive externality per unit. The new price will reflect this particular good's actual benefit to society. The efficient quantity will then be produced and consumed.Like costs, measuring the benefits to society that a positive externality can provide is problematic. That is why the resulting outcome of government intervention often brings the market towards the optimum equilibrium but does not always achieve it.

Correcting for externalities examples

Let's go over two practical examples of how the government corrects positive and negative externalities in the real world.

Consider a negative externality of emissions in a congested part of a city from cars that run on gasoline. The excessive amount of vehicles causes congestion, pollution, and noise in excessive amounts. Local residents are suffering from all these indirect costs. Clearly, the cost of driving in the center of the city is too low. The government can impose a congestion charge that would make cars pay a fee if they cross a certain threshold to enter this area. This would reduce the number of vehicles that enter the central city, thereby reducing a negative externality.

Consider the benefits that education brings to the whole population. A higher level of education reduces crime rates, promotes economic growth through employment, and improves the standard of living. That is why governments in many countries across the globe partially or fully subsidize the cost of public education. Primary and secondary education is almost free in most countries, with some higher education institutions offering considerable price reductions for high achievers.

Creating a market for negative externalities

Another solution implemented by governments across the globe is creating a market for negative externalities. A great example is tradable emission permits adopted due to the Clean Air Act of 1990. While the total emissions are capped, the factories can utilize the free market to trade these emission permits. The factories that are less efficient in pollution reduction would have to spend more to acquire those permits. In contrast, the more efficient factories can trade these permits for money. The free market mechanism allows permits to be allocated to the entities that value them the most. They provide incentives for reducing emissions and allow for certain flexibility to reduce pollution in the most feasible way, thereby eliminating the negative externality.

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Which of the following is an example of a negative externality quizlet?

Which of the following is the best example of a negative externality?

Which of the following is an example of a negative externality?