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Free EssaysEconomics CategoryEconomics of Externalities and HealthBuy an essay
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An externality is a benefit or a cost that is not accounted for in the price of a good or service and which is incurred by a party who has not been involved in the transaction of the good or service causing the benefit or cost. While the cost of an externality is called a negative externality, the benefit of an externality is called positive externality. In both externalities, prices of goods and services do not include the benefit or cost of consuming or producing the good or service.


The effect of a negative externality is an increase in production of a good or service. For example, pollution costs are often not incurred by most manufacturers. As a result, they tend to overproduce goods or services, if they operate in a competitive market. The marginal social cost of producing is usually higher than the marginal private cost (Caplan, 2003). This means that there are more social costs due to outcomes such as pollution. The effect of a positive externality is production of fewer goods. For example, if measures that ensure public safety are introduced, private firms will have reduced business. Outcomes from externalities are not socially optimal. This is mainly because the parties who enjoy positive externalities do not meet the costs while those who suffer from negative externalities do not ask for it. The end result of a positive externality is an improved societal welfare. The benefits are not monetized, thus fewer goods or services are produced. Increased free education incentives can, for instance, lead to improved standards of living and lower crime rate, among other benefits (Weisbrod, 1962).  Positive externalities are prone to the free rider problem. This is a situation where most members of a society take part in the public initiatives, so as to enjoy benefits maximally, but their interests contradict with those of a few, who want to make no effort at all. The free riders threaten the objectives of the wider society, such as increased empowerment or public safety. If a free rider, for example, does not participate in a vaccination against a contagious disease, he or she may catch the disease and then infect others. Such situations result in higher medical expenses for the victims or on the part of government.

There are various consequences associated with negative externalities. Air pollution emitted through exhaust fumes, and burning fuels endangers public health.  Furthermore, greenhouse gas emissions are a major source of climate change. This has been witnessed through increasingly high temperatures. The gases arise from burning of coal, gas and oil. Many processing and manufacturing plants release their wastes into water bodies. The untreated water causes diseases such as cholera and may, which in extreme cases, lead to death.  The net result of, for example, air pollution is lowered utility and displeasure and increased medical expenses. Air pollution may cause infection to the lungs. Individuals may, as a result, have breathing problems.

One way of dealing with positive externalities is taxation. The services paid for include fire and police protection. Taxation reduces the free rider problem.  Road maintenance fees, may, for instance, reduce the number of private cars on the roads, and many motorists will consider using public transport. Another way is putting forward a legal requirement for citizens to purchase insurance. A health insurance statutory requirement, for example, helps lower the insurance costs for unhealthy individuals. A subsidy program may be introduced to enable individuals increase their marginal benefits, they will therefore consume more goods or services. As a result, more goods and services will be demanded from the private sector.

Negative externalities are reduced mostly by measures outside of the competitive market set-up. Collective action is always necessary. The government can, for instance, discourage use of products such as polythene bags through more taxation. It can ban its production or importation altogether. It can introduce economic incentives in order to encourage production. For instance, it may introduce special tax tariffs. Governments, federal or state, have banned smoking in public and have often designated some areas to be smoking zones/areas.  Cigarettes and alcohol consumers have been paying an increasingly high tax on these products. A pigovian tax is effective in reducing a negative externality. It is equal in value to the cost/negative externality. It therefore helps balance the marginal private costs and marginal social costs (Barnett & Yundle, 2005). Governments also pass legislation on the acceptable amount of emission to water bodies or to the atmosphere. When the limit is exceeded, offenders pay for the excess of emissions as required by law (Thomas, 1994). Sale of pollution permits is another effective measure of controlling pollution.  Government departments responsible for environmental conservation have a duty to provide more information regarding pollution activities and the associated consequences (Varian, 1994). The international community has established the acceptable levels of emissions of green house gases. Summits are often held to follow up on ongoing programmes (Stern, 2006).

Alternatively, parties can organize payments such that they pay for their actions individually. The parties will pay each other after reaching an agreement over the efficient outcome. An agreement leads to formation of a contract. This way of solving the externality problem by private parties is possible if transaction costs are minimal, and if property rights are well defined. The method is called the Coase Theorem. It is a unique concept where private parties solve their problems themselves. Even when the government intervenes, the intention is to help draw binding agreements (Marney, 1791).


An externality is a benefit or a cost that is not accounted for in the price of a good or service and which is incurred by a party who has not been involved in the transaction of the good or service causing the benefit or cost. Many processing and manufacturing plants release their wastes into the atmosphere and also into water bodies. Untreated water causes diseases such as cholera and may, in extreme cases, lead to death.  The net result of, for example, air pollution is lowered utility and displeasure and increased medical expenses. Governments can introduce subsidies to encourage citizens purchase a product. They can increase taxes and pass legislation requiring purchase of health insurance policies in order to eliminate the problem of the free rider. These strategies reduce positive externality problems. To control negative externalities, such as pollution, specific measures are taken. They include: issuance of pollution permits, increased taxation, and specified emission amounts, legal suits for offenders, and facilitation of contracts so that parties involved resolve their conflicts.

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