An externality denotes a situation in which a third party not involved within a transaction incurs a benefit or cost (Amacher & Pate, 2013). That is, an externality occurs whenever a third party experiences side effects in a transaction between sellers and buyers. Whenever a third party gains from the transaction, it is termed a positive externality.
On the contrary, whenever a third party experiences a cost or loss it is referred to as negative externality (Amacher & Pate, 2013). For instance, a new fertilizer plant producing fertilizer for export also inflicts environmental air pollution. Residents of the area experience bad air quality due to air pollution, thus, a negative externality. The manufacturer never accounted for air pollution cost within production costs; therefore, fertilizer (product) is manufactured below the actual price (that tends to lead to over-production).
Another example: If a neighbor, makes a decision to repaint the house as well as spruce up the yard for a better price/cost when selling the house. The act also improves the market cost/value of the surrounding houses, creating a positive externality to the neighbors. On the contrary, a grade-A slob neighbor who lets the appearance of the house run down experiences a negative externality via depressing the attractiveness; therefore, the market value/cost of the entire neighborhood.
The government must address issues of externalities by encouraging positive externalities. The government must take corrective actions if the externality is negative, to prevent the behavior from proceeding and hurting the third party in an effort to achieve market efficiency. In circumstances such as of the new fertilizer plant producing fertilizer for export, the government must step in, by imposing a Pigouvian Tax, to make sure that the producer of fertilizer caters for the actual price or cost. The government must get involved guaranteeing that the selling cost reflects the price or cost to the surrounding or environment.
References
Amacher, R., & Pate, J. (2013). Microeconomics principles and policies. San Diego, CA: Bridgepoint Education, Inc.
