Updated: Aug 20, 2021

Externalities in consumption exist when the leve! of consumption of some good by one consumer has a direct effect on the welfare of another consumer, an effect which is not transmitted through the price mechanism; production externalities exist when the pro­duction activities of one firm directly affect the production activities of another firm. External economies of scale and diseconomies of scale are therefore particular cases of externalities in production. Examples of consumption externalities are:

(i) A, wanting privacy, builds a high fence, which reduces the amount ofsunshine flooding in through B’s window. (ii) A, in making a right turn on a busy road, causes a large traffic jam to build up behind him.

Examples of production externalities are:

(i) Firm A discharges effluent into a river, which greatly increases costs of Firm B downstream. (ii) Firm A sets up a training school for computer programmers, which increases the availability of programmers to Firm B.

There may also, of course, be mixed production/consumption exter-nalities. For example:

(i) Night flights by jets may cause residents in areas dose to an airport to lose sleep. (ii) Holiday motorists may increase congestion on a highway and so increase costs for lorry-drivers.

The essence of externalities, whether in production or consumption, is that their costs or benefits are not reflected in market prices, so the decision of the consumer or firm creating the externalities on the scale of the externality-creating activity does not generally take its effect into account. Hence, since the time of A.C. PIGOU, economists have argued that social welfare would be increased if the private consumption or production decision were modified so as to take the external effect into account. The means of <loing this were traditionally held to be the imposition of taxes on activities which created losses in welfare or increases in costs, and payment of subsidies on activities which increased welfare or lowered costs. In practice, tax-subsidy schemes are rarely adopted. More frequently, externalities are uncorrected, or absolutely prohibited – right turns in certain streets, smoking in certain parts of the aircraft – or property rights are created and redress is possible through the courts. If these property rights are well defined and it is not too costly to do so, the parties to an externality situation may get together and bargain, thus in effect creating a market the absence of which initially gave rise to the externality.

Reference: The Penguin Dictionary of Economics, 3rd edt.

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James Knight
Editor of Education
James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.