The meaning of externalities
What are externalities?
Externalities are costs (negative externalities) or benefits (positive externalities), which are not reflected in free market prices. Externalities are sometimes referred to as 'by-products', 'spillover effects', 'neighbourhood effects' 'third-party effects' or 'side-effects', as the generator of the externality, either producers or consumers, or both, impose costs or benefits on others who are not responsible for initiating the effect.
The key feature of an externality is that it is initiated and experienced, not through the operation of the price system, but outside the market.
Proponents of laissez-faire would argue that externalities particularly arise because of the absence of markets - as no markets exist for such things as clean air and seas, beautiful views or tranquillity, economic agents are not obliged to take them into account when formulating their production and consumption decisions, which are based on private costs and benefits i.e. those which are internal to themselves. Another way of putting this is to say individuals have no private property rights over such resources as the air, sea and rivers, and thus ignore them in making their production and consumption decisions.
Property rights refer to those laws and rules that establish rights relating to:
- ownership of property;
- access to property;
- protection of property ownership;
- the transfer of property.
Thus a firm may feel free to dump effluent into a river as the spoiling of the environment and the killing of fish is not a cost that it would directly have to bear. Those on the political left would be more likely to argue that such an externality would arise because of the market system which is based upon the private ownership of resources, with individuals acting in their own self interest and therefore not having to consider what is in the public interest i.e. the problem is due to an absence of communal property rights and of a system of planned production.