Externalities
Externalities are costs or benefits of an activity that spill over to others and are not reflected in its price. Taxes, subsidies, or other policies can bring private incentives closer to those wider effects.
THE IDEA
Supporting Idea: Externalities
An externality occurs when an activity imposes costs or provides benefits to others without those effects being reflected in the price. Because the decision-maker does not bear all the costs or receive all the benefits, the amount of the activity can differ from what would be socially desirable.
One response to a negative externality is to charge for the additional harm caused. The relevant incentive is the marginal cost of the activity. This means that the party responsible must pay for each additional unit of externality they cause.
For example, charging people each time they drive in the center of a city is more effective than charging a flat fee for driving in a city. With a flat fee, an additional trip costs the driver nothing extra. A per-trip fee changes the incentive for each additional trip.
Vaccination can create a positive externality when it reduces transmission and thereby protects other people. That benefit to others is one reason to subsidize vaccination. Its size depends on the disease and vaccine.
When to use it
Urban planners designing congestion charges for city centers.
Public health officials setting vaccine prices or subsidies to account for herd immunity.
Environmental regulators implementing carbon taxes or tradable permits for pollution.
Companies assessing the social impact of their operations and internalizing external costs.
FROM THEORY TO EVERYDAY LIFE
In practice
Congestion Pricing
A flat access fee leaves the price of another trip into a city center unchanged. A per-trip congestion charge gives drivers a reason to reconsider each additional trip. Whether the charge improves traffic depends on its design and the alternatives available.
Vaccines as Positive Externality
When vaccination reduces transmission, people other than the recipient can benefit, including people who cannot receive that vaccine. Subsidies can encourage uptake by accounting for this benefit to others.
A MOMENT TO REFLECT
Put it to work.
Can you identify a negative externality in your daily environment? How could a marginal cost be applied to reduce it?
What positive externalities exist in your community, and what mechanisms encourage or discourage their provision?
How would a per-use charge and a flat fee change the incentive for one additional use of a resource?
CONTINUE THE CONVERSATION
Source texts
- The Great Mental Models Volume 4 Economics and Art