Fundamentals of Business

8.1.4 Externality (spill-over)

An impact on any party not involved in a given economic transaction. An externality occurs when a decision causes costs or benefits to third party stakeholders, often, although not necessarily, from the use of a public good. In other words, the participants in an economic transaction do not necessarily bear all of the costs or reap all of the benefits of the transaction. For example, manufacturing that cause’s air pollution imposes costs on others when making use of public air.

In a competitive market, this means too much or too little of the good may be produced and consumed in terms of overall cost or benefit to society, depending on incentives at the margin and strategic behaviour.

Examples of externalities

Many negative externalities are related to the environmental consequences of production and use. . Pollution of any form that causes nuisance or harm to others.
. The harvesting by one fishing company in the ocean depletes the stock of available fish for the other companies and over fishing may result.
. Individuals collectively choose to use a public transportation resource (such as roads), imposing congestion costs on all other users.
. A business may purposely under fund one part of their business, such as their pension funds, in order to push the costs onto someone else, create an externality.
. Consumption by one consumer causes prices to rise and therefore makes other consumers worse off, perhaps by reducing their consumption.
. Accidents caused by alcohol abuse or any other human action
. Common costs of declining health and vitality caused by smoking and/or alcohol abuse.

Solutions

Externalities can be resolved by agreement between the parties involved. The first, and most common type of agreement, is tacit agreement through the political process. Governments are elected to represent citizens and to strike political compromises between various interests. Normally governments pass laws and regulations to address pollution and other types of environmental harm.

These laws and regulations can take the form of "command and control" regulation (such as setting standards, targets, or process requirements), or environmental pricing reform (such as eco-taxes, tradable pollution permits or the creation of markets for ecological services.
The second type of agreement is explicit agreement through bargaining.