Production externality is an unintended effect from an industrial activity, like a paper mill releasing waste into a river. These externalities often happen without anyone asking for them and can affect the economy, society, or the environment.
Production externalities refer to the gap between the actual cost of making a product and the true cost to society. These externalities can have positive effects, negative effects, or a mix of both.
Understanding about Production Externality
Production externalities are common, including issues like pollution and the loss of natural resources.
For instance, a logging company might cover the cost of cutting down a tree, but restoring a whole forest is much more expensive than just replacing the individual trees. Traffic congestion on highways and health issues from secondhand smoke are other examples of production externalities. A significant case of negative production externality is the Flint water crisis that occurred in 2019.
The British economist A. C. Pigou was the first to identify production externalities as a widespread issue. He claimed that when externalities exist, we cannot reach Pareto optimality, even in a perfectly competitive market. With externalities, the overall social benefit or cost is a mix of private and external benefits or costs. You should learn more about Pigovian Tax.
Negative Production Externality
A negative production externality occurs when an activity harms someone who is not involved in it. There are some examples:
- Loud music from an apartment can disturb neighbors and cause them to lose sleep.
- More use of antibiotics leads to more infections that are resistant to treatment.
Positive Production Externality
A positive production externality, known as an “external benefit” or “beneficial externality,” refers to the good impact an activity has on someone not directly involved. This is similar to a negative externality.
For instance, consider a farmer who raises bees for honey. One positive side effect of this is that the bees help pollinate nearby crops. The benefit from this pollination might be greater than the value of the honey produced. There are some examples:
- The building and running of an airport will help local businesses by making it easier for people to get there.
- A manufacturing company offers first aid training for workers to improve safety at work. This training could also help save lives beyond the workplace.
Conclusion
Production externalities are significant economic phenomena that affect third parties outside of a market transaction. They can be either positive or negative, leading to benefits or costs that are not reflected in the price of goods and services. Negative externalities, such as pollution from manufacturing, often require government intervention through taxes or regulations to mitigate societal costs. Positive externalities, like innovation and research, can justify subsidies or incentives to promote greater public benefit. Understanding production externalities is crucial for creating policies that balance economic activity with social welfare, ensuring that markets operate efficiently while minimizing unintended consequences.