Question

What is a negative externality? Give an example of one. Explain why your example is an externality. How does society (via government action) deal with negative externalities?

Answer 1

Whenever an action of one economic agent directly affects the welfare of another economic agent, it is termed as an externality. When this effect is negative, it is termed as a negative externality. A very simple example is that of a factory polluting a river, which is the source of drinking water of a settlement along its banks. Here, the pollution is proving to be a negative externality by the factory on the people, because the activities carried out within the factory has some (negative) consequences on the people. These costs imposed on the people are called spillover costs.

The society, via the government, can intervene in a number of ways to rectify this situation. An obvious way is to tax the production which is causing these spillovers to minimize them. The higher costs, thus imposed on the factory would include the spillover costs caused by them. Another way is to issue direct guidelines under which the agencies are supposed to function. In our case, it could be in the form of anti-pollution guidelines. Outright bans on undesirable activities is also a way.