Question

What is the role of government in dealing with positive externalities and negative externalities? Can you think of an example where the government dealt with an externality in the recent economy? In your opinion, was it effective?

Answer 1

An externality is the effect on a third party which is usually caused by availing a particular good or service. Positive externality is the optimistic spillover which is gained from the goods or service. For instance, while public education may directly affect only the schools and their students, an educated population will extend positive effects on the society as a whole. A negative externality, on the other hand, is a pessimistic spillover effect on a third party. For instance, passive smoking could adversely affect people’s health, even if they don’t directly indulge in smoking.

Government can play a role in reducing negative externalities by taxing goods when their production generates spillover costs. This taxation effectively increases the cost of producing such goods.

In cases of positive externalities, the role for government is to encourage more of an activity to be undertaken. Government can do this by subsidizing the activity from tax revenues or by simply providing the activity itself, as in the case of public goods such as national defense, lighthouses, clean air and water.

An externality occurs when a market transaction affects people who are not involved in that transaction. For example, when I buy power from my electricity company, a generator somewhere in Victoria’s Latrobe valley works a little bit harder and makes some extra greenhouse gases. I pay for the electricity and that money compensates the electricity retailer, distributor, transmission company and the generator. But people who are adversely affected by the pollution receive no compensation. They suffer a ‘negative externality’.

With a negative externality, like pollution, the market tends to over produce the relevant commodity. Too much electricity is produced using coal because the buyers of that electricity do not face the full costs of their actions. If they did, they would buy less.

Recently, an Indian Economy dealt with New Delhi air pollution as a negative externality and it was caused by both public and private entities and government intervened and policy was framed and even introduced in Indian union budget and several stances were taken but effectiveness is good for short term but in the long trun,yet to see how the government policy will be effective.