*DAY
#16 11.04.2020*
*TOPIC
– GDP and Externality *
WHAT
IS AN EXTERNALITY?
An externality is a cost or benefit of an economic
activity experienced by an unrelated third party. The external cost or
benefit is not reflected in the final cost or benefit of a good or service.
Therefore, economists generally view externalities as a serious problem that
makes markets inefficient, leading to market failures. The externalities are
the main catalysts that lead to the tragedy of the commons.
The primary cause of externalities is poorly defined
property rights. The ambiguous ownership of certain things may create a
situation when some market agents start to consume or produce more while the
part of the cost or benefit is covered or received by an unrelated
party. Environmental items, including air, water, and wildlife, are the
most common examples of things with poorly defined property rights.
TYPES
OF EXTERNALITIES
Generally, externalities are categorized as Production
externalities and Consumption externalities.
PRODUCTION
EXTERNALITY - Production externalities are categorized in
negative and positive externalities.
1.
Negative externality
A negative externality is a negative consequence of an
economic activity experienced by an unrelated third party. The majority of
externalities are negative. Some negative externalities, such as the different
kinds of environmental pollution, are especially harmful due to their
significant adverse effects. Examples of negative production externalities include:
·
Air pollution: A
factory burns fossil fuels to produce goods. The people living in the
nearby area and the workers of the factory suffer from the deteriorating air
quality.
·
Water pollution: a
tanker spills oil, destroying the wildlife in the sea and affecting the people
living in coastal areas.
·
Noise pollution: People
living near a large airport suffer from high noise levels.
2. Positive
externality
Positive externality is a benefit from an economic
activity experienced by an unrelated third party. Despite the benefits of
economic activities that involve positive externalities, the externality also
creates market inefficiencies. Positive externalities can also be distinguished
as production and consumption externalities.
Positive
production externalities include:
·
Infrastructure development: Building
a subway station in a remote neighborhood may benefit real estate agents who
manage the properties in the area. Real estate prices would likely increase due
to better accessibility, and the agents would be able to earn higher
commissions.
·
R&D activities: A
company that discovers a new technology as a result of research and
development (R&D) activities creates benefits that help the society as
a whole.
CONSUMPTION
EXTERNALITY – Consumption externalities are categorized in
negative and positive externalities.
1.
Negative externality
A negative externality is a negative consequence of an
economic activity experienced by an unrelated third party. The majority of
externalities are negative. Some negative externalities, such as the different
kinds of environmental pollution, are especially harmful due to their
significant adverse effects. Some examples of negative consumption
externalities are:
·
Passive smoking: Smoking
results in negative effects not only on the health of a smoker but on the
health of other people.
·
Traffic congestion: The
more people use roads, the heavier the traffic congestions are.
2. Positive
externality
Positive externality is a benefit from an economic activity
experienced by an unrelated third party. Despite the benefits of economic
activities that involve positive externalities, the externality also creates
market inefficiencies. Examples of positive consumption externalities are:
·
Individual education: The
increased levels of an individual’s education can also raise economic
productivity and reduce unemployment levels.
·
Vaccination: Benefits
not only a person vaccinated but other people as well because the probability
of being infected decreases.
SOLUTIONS
TO EXTERNALITIES
Due to the adverse effect of both negative and positive
externalities on market efficiency, economists and policymakers intend to
address the problem. The “internalization” of the externalities is the process
of adopting policies that would limit the effect of the externalities on
unrelated parties. Generally, the internalization is achieved through
government intervention. Possible solutions include the following:
1.
DEFINING PROPERTY RIGHTS
The
stricter definition of property rights can limit the influence of economic
activities on unrelated parties. However, it is not always a viable option
since the ownership of particular things such as air or water cannot be
unambiguously assigned to a particular agent.
2.
TAXES
A
government may impose taxes on goods or services that create
externalities. The taxes would discourage activities that impose costs on
unrelated parties.
3.
SUBSIDIES
A
government can also provide subsidies to stimulate certain activities. The
subsidies are commonly used to increase the consumption of goods with positive
externalities.
As
content have been taken from other sources.)
Reference
Videos
Externality
and GDP
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Regards
Dr.
Asad Ahmad
KV
IIM, Lucknow
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