According to Wikipedia,
"An externality is a cost or benefit that is not transmitted through prices and is incurred by a party not involved as the buyer or seller of the goods or services causing the cost or benefit."
Pollution is the best example to illustrate this concept.
When you buy gasoline (a good) from King Soopers to fill up your car, you (the buyer) pay King Soopers (the seller) $3 per gallon of gasoline (the price). You obtain the benefit of driving your car, which is reflected by the price of $3 per gallon. However, there is another cost at work. When you run your car, some amount of pollution escapes into the atmosphere. This pollution (the externality) risks health (the cost not transmitted in the price of the gasoline) of whoever breathes in the affected air (the party not involved as the buyer or seller).
This is an externality that deals with an added cost. It's a problem because the producers of gasoline have no incentive to reduce this cost, and the cost is not factored in to the decision of the buyer.
Because of externalities, consumers might make inefficient decisions- decisions in purchasing a good that is more costly for what it does than another similar good.
For example, let's say King Sooper's gasoline has a listed price of $3 per gallon, but costs an additional $1 per gallon as a result of the harmful effects of the pollution it creates. On the other hand, Costco sells more eco-friendly gasoline for $3.30 per gallon, which only costs an additional 20 cents as a result of reduced pollution.
In this case, the actual cost of King Soopers gasoline is $4 per gallon, versus Costco's gasoline at $3.50. However, consumers are more likely to purchase King Soopers gasoline, since the internal cost (the cost to the buyer) is merely $3, versus Costco's $3.30. The added costs are external, thereby making them externalities.
The "solution" to this problem has long been government intervention. If King Soopers is taxed- $1 per gallon of gasoline- and Costco is taxed- $.20 per gallon of gasoline- and then that money was directly distributed to those who incurred the cost of pollution, the externality could be accounted for.
Unfortunately, the government rarely operates in the way intended. When we apply realism, this ideal situation never manifests. Taxes are complicated, and many gasoline companies receive subsidies. Furthermore, the cost of externalities has yet to be determined (the government may as well be pulling a number out of a hat regarding 'what is the added cost'?), and the tax money they *do* receive is hardly given to those effected by the externality. Instead it is added to a large pool of funds, which are distributed to a wide array of programs (ranging in effectiveness from inefficient to harmful) that ultimately have nothing to do with the problem that we started with.
Fortunately, people do recognize externalities in products they purchase.
Eco-friendly options have been praised in the private sector without government influence because that's what people have decided they want to buy. They recognize, at least in part, the harmful effects of pollution- to an appropriate extent- and they act accordingly. It won't be exact, but the market accounts for externalities by tending to choose options that have less cost to others not involved in the transaction. The fact is that no "solution" to the problem of externalities is perfect, and there has yet to be formed an answer that accounts for them entirely, but when government is involved it can be counted on to make matters worse.
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