Per Tse (2025) an externality is when the free market doesn’t recognise when there’s an external cost or benefit to other people.
Per Kenton (2024),
When there’s costs, it is a negative externality, which imposes an indirect cost.
When there’s benefits, it is a positive externality, which provides an unintended benefit.
Externalities are divided into production based externalities (as a result of producers) called production externalities, or consumption based externalities (as a result of consumers), calling consumption externalities.
Per Tse (2025):
Examples of negative externalities:
- Car exhaust/air pollution (negative consumption externality)
- airport pollution (sound) (negative production externality)
- lawn mowers (negative consumption externality)
- mining (negative production externality)
Examples of positive externalities:
- immunisation (positive consumption externality)
- vaccination (positive consumption externality)
- education (positive production/consumption externality)
- research (positive production externality)
Solving Externalities
Per Tse (2025), private solutions can be made: this includes moral codes, social sanctions, private donations, or contracts. But how effective is this really? The coarse theorem highlights two fundamental aspects involved in the transaction between two parties when completing a private solution, both of which often fail. If the private solution is impossible, the government must step in and solve the externality.
The government has a few options per Tse (2025):
Command and control policies (regulations)
Market based policies (taxes (for negative externalities), subsidies (for positive externalities)
Tradable permits whilst taxes say “every time you emit xyz of C02 you pay xyz” tradable permits say “you can emit however much you like, as long as you own/buy a permit.” Each permit allows the owner to emit a certain quantity of pollution, and this permit can be traded in a market. (Supply of pollution permits is set by government, but demand moves around depending on firms demand. If you’re a firm and you need to pollute to make profit, YOU will be willing to pay the higher price for pollution permits, driving up the price).
Works cited:
Tse, Harry. “Lecture-3 Equilibrium Elasticity.” 2025.
Kenton, Will. “Externality: What It Means in Economics, with Positive and Negative Examples.” Investopedia, 18 June 2024, www.investopedia.com/terms/e/externality.asp.
