Externality is when one agent’s actions directly affect another agent at the same time not altering the price of the good or service. Two types of externalities are known, negative and positive externality. Negative externality is the case when one agent’s actions cause the second agent to lose welfare, and the second agent is not compensated for that. The opposite takes place with positive externalities. When one agent’s actions cause the second agent’s welfare to increase, and if he/she is not compensated for that, then it is known to be a positive externality.
One example of the externality is the consumption of unhealthy food. This causes negative externality, because eating unhealthy food results in less productivity of people and increases the probability of usage of nationalized healthcare. The marginal product cost of unhealthy food is thus less than marginal social cost. The only way to correct for this externality is to make both consumers and producers pay for it. By imposition of taxes, the quantity consumed will decrease. In addition, government will collect revenue that will be used for increasing the welfare of the society.
Another example of the externality is related to production activities of Production Company Huy Fong Foods in Irwindale, LA. The product they make is a famous hot sauce Sriracha, which is negatively affecting the residents of the region as its painful odor burns their eyes, irritates their noses and causes headaches. The residents of the city constantly complain about the odor and filed suit in Los Angeles Country Superior Court asking a judge to stop the production until the smell is reduced. However, it is worth to note that the factory is one of the big production companies of the area, which is improving the economic condition of the region and providing jobs for hundreds of people, which will lead to negative consequences if the production stops. There are some possible ways of policies to achieve social optimum quantity and correct negative externality: levy a tax (If the government knows how much smell is produced per unit of production output, and then it can set a tax on production output. However, the relationship between the smell and production output is very difficult to estimate with any degree of precision.); impose subsidy (Subsidy for each unit of output that is not produced. However, in the long run, such subsidies for reduction may increase the negative externality because the subsidy may attract more firms into the market.); government regulations, such as restriction, standard, or quota.
The last example, I am going to use is an extreme example of a positive externality, and it is connected to drug-related crime rates in the country. One possible way to correct this problem is to decriminalize drugs. 12 years experience of Portugal, who was the first EU country to decriminalize drugs, now reaps the results of the lowest drug consumption rates of the entire Europe. It would be fair to say, that decriminalization has a positive externality in terms of public policy as it decreases marginal social cost. Marginal social benefits from this policy are greater than marginal private benefits. The marginal social cost and marginal private costs will simultaneously decrease. Decriminalization is a good policy towards reducing drug-related crimes; however, it is important to take into consideration the policy environment of the country before implementing the policy.
References
Drug policy: Supply and Demand. (n.d.).The Economist. Retrieved February 16, 2014, from http://www.economist.com/node/1877264
Mankiw, N. G. (2004). Chapter 10, Externalities. Principles of microeconomics (3rd ed.). Mason, Ohio: Thomson/South-Western.
Pindyck, R. S., & Rubinfeld, D. L. (2005). Chapter 18, Externalities and Public Goods. Microeconomics (6th ed.). Upper Saddle River, N.J.: Pearson Prentice Hall.
Shyong, F. (2013, October 28). Sriracha sauce factory odor causing headaches, burning eyes, city says. Los Angeles Times. Retrieved February 16, 2014, from http://articles.latimes.com/2013/oct/28/local/la-me-ln-irwindale-sues-sriracha-20131028
