Externalities exist when a third party bears costs or receives benefits arising from an economic transaction in which he or she is not a direct participant. This occurs when producers or consumers provide benefits to third parties or impose costs on third parties for which the market system does not enable them to receive full payment in return.
A harmful externality occurs, for example, when a factory generates pollution. Individuals who live and work in the neighbourhood bear costs arising from the factory's production, including adverse health effects and clean-up costs.
A beneficial externality occurs, for example when Mr Francois paints his house and enhances his neighbours' views and the values of their properties.
Externalities arise with any interdependency of household utility or firm production functions that is not reflected in market prices. Such externalities result in inefficiency and are nonpecuniary externalities. However, when all affected parties have directly operated through the market price system, they are identified as pecuniary externalities, and pose no inefficiency.
When nonpecuniary externatlities are present, resources are likely to be misallocated by producers or consumers whether the externality is beneficial or harmful to its recipients. This misallocation or resources occurs because the price system fails to provide the correct signals to firms making output and resource allocation decisions.
However, there are solutions to externalities.
Firstly, the solution to misallocation of resources is clear. An external cost, for example, should be reduced up to the point where marginal spillover costs saved by any further reduction just equal the marginal lost profits from the externality generating activity. Similarly an action that...