Externalities, or "spillover effects," are the effects of actions that are external to, or do not directly affect, the entity performing the act. These effects may be either positive or negative. In economics, externalities are the effects of an action which are not reflected in market prices. Examples of negative externalities would be an increase in pollution and traffic due to a plant expansion. The costs of the increased pollution, the increases in road maintenance, fuel costs, and lost time due to increased traffic, would not ordinarily be borne by the firm. Examples of positive externalities would include reductions in traffic from a city bus system, or a reduction in pollution due to a new manufacturing process. The savings in road maintenance, fuel costs, and time, and the benefits of reduced pollution, would not be captured by the bus system and the firm. The result of externalities is a socially suboptimal allocation of resources. In the negative externality examples, the socially optimal allocation would be smaller than the actual allocation because the external costs would not be reflected in the firm's planning. In the positive externality examples, the actual allocation would be smaller than the socially optimal allocation because the firm would not be able to capture the external benefits.
Externalities are a market imperfection, and a number of remedies are available. Social pressure and education can remedy some problems, but this seems to be limited to low-cost externalities. Regulation, such as emission limits, has also been applied. In some cases taxes are used to reduce negative externalities or to recover some of the cost for society. The reverse of taxes is the use of subsidies (or sometimes tax credits) to provide some of the positive externalities to the decision unit. Legal rights to recover from the decision unit damages resulting from externalities may also be effective.
While externalities are easily overlooked, consideration of externalities is an important part of planning. First, while the planning entity may not be directly affected, there is often a change in goodwill (or bad will) toward the entity. This may cause an indirect or secondary effect, as the planning entity may face a boycott or decreased cooperation from the affected group. Second, externalities may lead to direct effects in the future. Note that some remedies for externalities are imposition regulations or an increase in taxes. Third, in some cases, the firm can recapture some of the externalities through bargaining with the affected parties, through such means as tax reduction or subsidies. Examples are the financing, tax abatement, and provision of facilities commonly used to attract industry. Finally, examination of externalities is also important for ethical considerations. Goodwill or bad will aside, the adoption of a project that is profitable to the initiating entity may have effects on others that preclude its acceptance on ethical grounds.
Externalities are often used to justify adoption of public projects such as the Tennessee-Tombigbee Waterway, or various space programs. It can be argued that for public entities there are no externalities, i.e., since the public entity exists for the good of all, all effects must be taken into account in public planning. In the example of the bus system, it would not be economically correct to shut down the system simply on the basis that the fares did not cover the costs. Further, it would not be economically correct to simply set the fares on the basis of covering costs. The proper fare structure would instead be one that maximized the sum of all benefits to all citizens. If there are externalities, setting fares below cost to attract more users may be the best economic action.
[ David E. Upton ]
Bromley, Daniel W. Environment and Economy: Property Rights and Public Policy. Cambridge, MA: Basil Blackwell, 1991.
Comes, Richard, and Todd Sandler. The Theory of Externalities, Public Goods, and Club Goods. 2nd ed. New York: Cambridge University Press, 1996.
Cowen, Tyler, ed. The Theory of Market Failure. Fairfax, VA: George Mason University Press, 1988.