Markets are sensitive only to benefits or costs that can be translated into willingness to pay on the part of buyers, or into costs incurred by sellers. An economic choice or action by one economic actor that affects the welfare of others who are not involved in that choice or action is called an externality. In defining externalities we focus on effects that impinge on third parties through non-market channels. More specifically:
- A negative externality (sometimes referred to as an “external cost”) exists when an economic actor produces an economic cost but does not fully pay that cost. A well-known example is the manufacturing firm that dumps pollutants in a river, decreasing water quality downstream.
- A positive externality (sometimes referred to as an “external benefit”) exists when an economic actor produces an economic benefit but does not reap the full reward from that benefit. Positive externalities are less well-known, but can be vitally important to individual and societal well-being. A landowner, for example, by choosing not to develop her land might preserve a water recharge source for an aquifer shared by the entire local community. Other examples are parents who, out of love for their children, raise them to become decent people (rather than violent criminals). In so doing they also create benefits for society at large. Similarly, when one person gets vaccinated against a communicable disease, she not only protects herself, but also others around her, from the disease’s spread. In both cases there are social benefits from individual actions: Well-educated, productive citizens are an asset to the community as well as to their own families; and disease control reduces risks for everyone.
When a market transaction affects the welfare of third parties who are not involved in the transaction, the market behavior of the economic actors will not reflect all the preferences of, or all the costs to, everyone affected. This is because the costs or benefits affecting the particular actors differ from the costs or benefits to society as a whole. For example:
- If the cost of polluting is not borne by the polluters, they will not feel an economic motivation to reduce their creation and discharge of wastes.
- If employers do not benefit in full from the cost of providing training to their employees, they are likely to provide less of that training than is socially desirable.
- If the price of water or of petroleum is set below the true cost to society of using these resources, this will produce an incentive to use too much of them.
Externalties can also be either technological or pecuniary. Pecuniary externalties involve external effects that are transmitted through higher prices. For example the value of residential land may increase because surrounding employers expand their operations, and the new labor force creates a scarcity of residential land in the area. Unlike technological externalities, pecuniary externalties do not generally result in inefficent allocations.
Technological externalties occur when a person's well-being or a firm's costs are directly affected (as opposed to being indirectly affected through the price system). For example, a water bottling operation that finds its source contaminated by pollution is experiencing a negative technological externality.
In general, each of these examples involves a situation in which there is a difference between private and social costs (or benefits); as a result, the monetary incentives of the marketplace encourage socially undesirable behavior. If all of the things that flow through an economy are paid for according to their full social as well as private value (including things that have negative value), this will provide the motivation for these things to be produced in proportions that correlate precisely with their full value. That is a good first approximation for a definition of economic efficiency. If economic activities affected only the actors directly involved in decision-making about them, we might be able to think about economic activity primarily in terms of individuals making decisions for their own benefit. But we live in a social and ecological world, in which actions, interactions, and consequences are generally both widespread and interknit. If decisions are left purely to individual self-interest, then from a societal point of view too many negative externalities will be created, and too few positive externalities: The streets might be strewn with industrial wastes, while children might be taught to be honest in dealings within their family, but not outside of it. Market values and human or social values do not always coincide.
Some of the most important externalities have to do with the economic activity of resource maintenance: Relying on markets alone to coordinate economic activities allows many activities to happen that damage or deplete the natural environment, because the damage often does not carry a price tag, and because people in future generations, who will be most affected, are not direct parties to the decision-making.