What Are Externalities?

• Author: Thomas Helbling
• Position: an Advisor in the IMF's Research Department.

Back to Basics

CONSUMPTION, production, and investment decisions of individuals, households, and firms often affect people not directly involved in the transactions. Sometimes these indirect effects are tiny. But when they are large they can become problematic—what economists call externalities. Externalities are among the main reasons governments intervene in the economic sphere.

Most externalities fall into the category of so-called technical externalities; that is, the indirect effects have an impact on the consumption and production opportunities of others, but the price of the product does not take those externalities into account. As a result, there are differences between private returns or costs and the returns or costs to society as a whole.

Negative and positive externalities

In the case of pollution—the traditional example of a negative externality—a polluter makes decisions based only on the direct cost of and profit opportunity from production and does not consider the indirect costs to those harmed by the pollution. The social—that is, total—costs of production are larger than the private costs. Those indirect costs—which are not borne by the producer or user—include decreased quality of life, say in the case of a home owner near a smokestack; higher health care costs; and forgone production opportunities, for example when pollution harms activities such as tourism. In short, when externalities are negative, private costs are lower than social costs.

There are also positive externalities, and here the issue is the difference between private and social gains. For example, research and development (R&D) activities are widely considered to have positive effects beyond those enjoyed by the producer—typically, the company that funds the research. This is because R&D adds to the general body of knowledge, which contributes to other discoveries and developments. However, the private returns of a firm selling products based on its own R&D typically do not include the returns of others who benefited indirectly. With positive externalities, private returns are smaller than social returns.

When there are differences between private and social costs or private and social returns, the main problem is that market outcomes may not be efficient. To promote the well-being of all members of society, social returns should be maximized and social costs minimized. Unless all costs and benefits are internalized by households and firms making buying...