Externality

A spillover cost or benefit to a society, and sometimes to the rest of the world. Externality may be linked to the overallocation and underallocation of resources. A spillover cost or benefit affects a third or external (nonmarket) party. Private costs are borne by producers and consumers of a good because producers incur costs in the process of producing a good, which can be transferred to consumers who will derive satisfaction from the consumption of such a good.

The social cost is the combination of the private cost and external or environmental cost. This identity makes it feasible to see that the external cost is the social-private cost differential. External benefits can analogously be understood as the social-private benefit differential.

[Page 195]The market supply curve of a firm or a firm's marginal cost (damage) curve (when it is not a monopolist) does not capture all the costs associated with production. The costs are much higher. As such, spillover costs are associated with overallocation of resources, a situation in which society is using up more resources than are necessary to produce the optimal outcome. Environmental pollution is a good example of external cost.

Conversely, external benefits indicate that the allocation of societal resources is suboptimal because the market is only responding to private wants, not social wants. For example, those who can afford the high cost of acquired immune deficiency syndrome (AIDS) drugs will purchase them, but not those who cannot afford them. Society is endangered because of the potential spread of the epidemic. If, however, a social planner can intervene with inoculations and preventive mechanisms, even those who are not immediate beneficiaries ultimately become beneficiaries because of the external effects of reducing infections. Those who are not active participants in the AIDS drug market become beneficiaries. Alternatively, policymakers can subsidize production of AIDS drugs.

Externality is therefore the result of market failure. The market cannot always achieve the best or optimal outcome, and therefore, some amount of intervention by policymakers may be warranted to minimize the external effects of market failure. Tools at the disposal of policymakers include regulation, taxes (to minimize external cost), and subsidy (to increase external benefit). For more information, see Field and Field (2006), McConnell and Brue (2008), and Schiller (2006).