Externalities (Economics) – Definition

Cite this article as:"Externalities (Economics) – Definition," in The Business Professor, updated November 22, 2018, last accessed May 27, 2020, https://thebusinessprofessor.com/lesson/externalities-economics-explained/.

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Externalities Definition

An externality is any positive or negative outcome of an economic activity that affects the population that does not have any stake in business or industry. For example, some economic activities may emit toxic pollution and waste materials that may affect health of residents of that locality. This is a negative externality. 

A Little More on Externalities
Externalities often occur when an industry or business activities affect those who are not related to production or consumption of goods and services. It may include pollution or waste materials that affect public health. This is one of the reasons that government becomes more active in regulating the business to restrain negative externalities.

Externalities Can be Positive or Negative

Most often, externalities are negative in how the affect the public. For example, waste materials or emission of pollution from industry are negative externalities. Further, a business may adopt the latest technology to cut the cost of production to realize more profits. The business may realize greater gains by expanding its production and sales, but it can result in higher social and public cost.

Some business activities may result in positive externalities as well. As new technologies are introduced, the business may increase profit without affecting the population. The is normally done by focusing on Research and Development (R&D) and incorporating corporate values. Resultantly, the productivity can be improved without affecting nearby population.

How to Overcome Externalities: Possible Solutions

There are several solutions to problems arises from externalities:

  • Taxes – The government may impose Pigovian tax (associated with economist Arthur C. Pigou) which imposes equal tax to the value of negative externality. These taxes significantly discourage business to spread negative externalities.
  • Regulations – The Government may impose more regulations on the business to overcome the negative externalities.

References for Externalities

Academic Research on Externalities

  • ●      Network externalities, competition, and compatibility, Katz, M. L., & Shapiro, C. (1985). The American economic review75(3), 424-440. This paper constructed a retailer-leading supply chain system considering the extended warranty (EW) with single manufacturer and single retailer to study the influence of network externality on retailer-leading supply chain coordination. Different analysis were also conducted with regards to different profit related terms. Results show that the network externality increased the loss of decision efficiency. This leads to further consideration of the coordination of the supply chain system with extended warranty.
  • ●     Technology adoption in the presence of network externalities, Katz, M. L., & Shapiro, C. (1986). Journal of political economy94(4), 822-841. This paper analyzes technology adoption in industries where network externalities are significant. The paper aims to show the different reason and impacts of technology adoption in these industries.
  • ●      Threshold externalities in economic development, Azariadis, C., & Drazen, A. (1990). The Quarterly Journal of Economics105(2), 501-526. Standard one-sector growth models often have the counterfactual implication that economies with access to similar technologies will converge to a common balanced growth path. The authors propose an elaboration of the Diamond model that permits multiple, locally stable stationary states. This multiplicity is due to increasing social returns to scale in the accumulation of human capital.
  • ●      Production, consumption, and externalities, Ayres, R. U., & Kneese, A. V. (1969). The American Economic Review59(3), 282-297. This paper focuses on the general view of externalities as an exceptional case. The authors proposes that at least one class of externalities must be viewed quite differently.
  • ●      Worms: identifying impacts on education and health in the presence of treatment externalities, Miguel, E., & Kremer, M. (2004). Econometrica72(1), 159-217. This paper examines the infection rate of intestinal helminths on world population. The paper aims to show the impact of phasing deworming drugs to groups, rather than to individuals. Results show that drugs were known to be more effective when distributed in this fashion, than when distributed individually. It was also known to boost active engagement of students in school events when distributed in a Kenyan school. The authors further discusses the impact of deworming on the health and academics of untreated students.
  • ●      Externalities in economies with imperfect information and incomplete markets, Greenwald, B. C., & Stiglitz, J. E. (1986). The quarterly journal of economics101(2), 229-264. This paper presents a simple, general framework for analyzing externalities in economies with incomplete markets and imperfect information.
  • ●      Why people use social networking sites: An empirical study integrating network externalities and motivation theory, Lin, K. Y., & Lu, H. P. (2011). Computers in human behavior27(3), 1152-1161. This study applies network externalities and motivation theory to explain why people continue to join social networking sites (SNS). This study used an online questionnaire to conduct empirical research, and collected and analyzed data of 402 samples by structural equation modeling (SEM) approach. The findings show that enjoyment is the most influential factor in people’s continued use of SNS, followed by number of peers, and usefulness. The findings suggest that gender difference also produces different influences. The implication of research and discussions provides reference for SNS operators in marketing and operation.
  • ●      Network effects without network externalities, Chou, C. F., & Shy, O. (1990). International Journal of Industrial Organization8(2), 259-270. The network externalities hypothesis postulates that consumers prefer to purchase brands which are bought by more consumers compared with brands with a low market share. This paper aims to show that increasing returns to scale in the production of complementary products can substitute for the network externalities assumption. A model for the computer industry in which the production of complementary software requires a large fixed cost of development relative to the cost of duplicating and marketing the software is developed for further experimenting.
  • ●      Spatial externalities, spatial multipliers, and spatial econometrics, Anselin, L. (2003). International regional science review26(2), 153-166. This article outlines a taxonomy of spatial econometric model specifications that incorporate spatial externalities in various ways. It explores the point of departure, also known as spatial multipliers, and goes on to derive a range of familiar and less familiar specifications for the structural form of a spatial regression.
  • ●      On taxation and the control of externalities, Baumol, W. J. (1972). The American Economic Review62(3), 307-322. This paper analyses the Pigouvian traditions, and its general acceptance in theoretical literature. The main purpose of this paper is to show that the conclusions of the Pigouvian traditions is in fact impeccable in its own ground.
  • ●      Adoption externalities as public goods, Dybvig, P. H., & Spatt, C. S. (1983). Journal of Public Economics20(2), 231-247. This paper analyses the concept of positive externalities and negative externalities.

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