Question

Give an example of a positive and negative externality and what regulations the government would use to correct the negative externality?

Answer 1

Background Information
An externality, especially in a free market economy, is a benefit (positive) or negative consequence (cost)of an economic activity that is experienced or encountered by a third party that is not related. For Instance, the increase in the productivity of a company as a result of a well-educated labor force is an example of a positive externality. Coming to negative externality, Pollutants emitted by a chemical factory that spoils and damages the surrounding environment and affects the health of nearby residents is an instance of a negative externality.

As per recent estimates, in the  United States of America, approximately 5 percent to 15 percent of the Gross Domestic Product is consumed by negative externalities. Consequently, unregulated and uncontrolled market of goods and services (having significant externalities) create prices that don't reflect the true social cost or benefit.

Other examples of Positive externality

• construction and operation of a railway station. This will benefit local businesses, because of the increased accessibility to the market in the nearby area.
• A foreign firm (entering in a particular geographical area) demonstrates updated technologies to local firms and improves their productivity also.

Other examples of Negative Externality

• Systemic risk- the risks born by the overall economy arising from the risks that the banking system takes. Repercussions can occur in the presence of badly designed regulation or in the absence of well-designed banking regulation.
• The depletion of the species of fish in the sea due to overfishing. This is an example of loss of common property resource, due to the absence of appropriate environmental governance.

What regulations the government would use to correct the negative externality?

Government can take the following steps to correct negative externality

1. Imposition of Pigovian tax

Imposition of Pigovian tax (named after economist Pigou) that is equal in value to the negative externality. Consequently, the market outcome would reduce to an efficient amount.

2. Passing of Environment laws prohibiting pollution. This will reduce negative externalities.

3. Mediation or negotiation between the two parties i.e. those affected by negative externalities and those causing negative externalities.

4. Filing suits in the court for negative externalities. Consequently, people causing negative externalities would avoid activities causing negative externalities.