Economics: Defining Externalities

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I think you'd be hard pressed to find a more obnoxious bumper sticker than this one and yet, apparently somebody paid two bucks for it. I've seen it on people's cars, which lets you know that the people are getting at least $2.00 worth of satisfaction from sharing this message with you. Now, I myself, will be willing to pay at least 25 cents to the person to keep them from putting the sticker on their car, from being spared having to encounter this message in traffic. And I can't be alone, because if there are 40 of us who feel that way, then we will be willing to take up a collection of $10.00 to pay the guy not to put it on his car. Right? He's getting $2.00 worth of satisfaction from it and we're getting $10.00 worth of dissatisfaction, collectively. So, why is the sticker on his car? It's because we're dealing with a particular kind of market failure called an externality.
An externality is a cost or a benefit that you can pass on to other people. Let's take the case of an external cost. An external cost is the cost of your transaction that is borne by someone who is not a party to your transaction. For instance, if I'm a box maker and I sell you a box, but I'm polluting the lake when I produce the box, the pollution is an external cost. It's a cost that's passed on to swimmers and fishermen and other people who aren't part of your and my transaction and yet they bear a cost. They're affected by our trade.
Suppose you buy a package of cigarettes from a vending machine. The vending machine sells you the cigarettes. You buy them because of the satisfaction, but when you light up in a crowded room, other people bear the cost of your decision. If you paint your house a color that your neighbors consider tacky, well, they're bearing the cost of your choice. You have externalized consequences. You have externalized cost of your action onto other people who are not part of the decision that creates the cost. That's an externality. Other people outside the transaction are affected.
There are also external benefits. Let's consider the case of a flu shout. Suppose I go to the doctor and get a flu shot. Well, I'm protected against the flu, but so are you. If you're students in my class or co-workers or my friends, now you don't have worry about me getting the flu and coughing and sneezing on you and perhaps subjecting you to the same kind of torment. You don't have to worry about the flu because you get a benefit from my flu shot. Now, chances are I didn't think about you when I went to the doctor and made the choice to get the shot, but you happen to get a benefit simply because I'm vaccinated. The benefit is external to my decision to get the shot. It's external to me. I made a private calculation. A private calculation of the benefit from the shot and the cost of getting it and if the private numbers worked out okay, if I made a profit off this deal, then I got a flu shot, if the cost was less than the benefit to me.
However, everybody else, all of my students and co-workers, they got a benefit too, from reduced risk of exposure. And that's an external benefit, because it's external to my choice to get a flu shot. They weren't part of the decision. Now, here's the problem. When there are externalities present, when there are external costs or external benefits, we cannot rely on the free market. We cannot rely on decentralized private choice to give us an outcome that maximizes economic value. In fact, in many cases a factory will see that's it's profitable to make their good and sell it to the market, because the revenue they bring in is greater than the costs they incur.
However, the revenue will only be greater than the cost, because they are able to dump part of the cost on other people, dump the pollution in the lake or in the air. If you added the true cost of the pollution onto the private cost of making boxes, the cost might be greater than the benefit. It might be socially unprofitable to make those boxes. Those boxes may actually be shrinking the pie, because the true benefit is less than the true social cost. However, the boxes get made anyway, because some of the costs can be externalized and they look privately profitable to the company.
The same might be true of my flu shot. When I think about the money I have to pay the doctor for this flu shot and the sore arm that I have to live with for three days, it may not be worth it to me, privately, to protect myself from the flu. However, the only reason I don't get the flu shot is because I am ignoring all of the benefits that are created for everyone else. If in fact, I somehow were experiencing or internalizing the external benefits, if I were getting a nickel for every person that I'm protecting against the flu by getting the shot, it might turn out to be a profitable venture for me to go to the doctor and get it anyway.
So, when there are external costs or external benefits, there are choices that get made that don't add economic value and there are choice that should be made, but aren't that would add economic value. In the next lecture we'll look at some specific examples, involving numbers that show how, in the presence of externalities, a market can fail. And, we'll suggest some remedial measures that might help increase economic value.
Market Failures
Externalities
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