Economics » Environmental Protection and Externalities » The Economics of Pollution

Key Concepts and Summary

Key Concepts and Summary

Economic production can cause environmental damage. This tradeoff arises for all countries, whether high-income or low-income, and whether their economies are market-oriented or command-oriented.

An externality occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. An externality, which is sometimes also called a spillover, can have a negative or a positive impact on the third party. If those parties imposing a negative externality on others had to take the broader social cost of their behavior into account, they would have an incentive to reduce the production of whatever is causing the negative externality. In the case of a positive externality, the third party is obtaining benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to under produce output because suppliers are not aware of the additional demand from others. If the parties that are generating benefits to others would be somehow compensated for these external benefits, they would have an incentive to increase production of whatever is causing the positive externality.

Glossary

additional external cost

additional costs incurred by third parties outside the production process when a unit of output is produced

externality

a market exchange that affects a third party who is outside or “external” to the exchange; sometimes called a “spillover”

market failure

When the market on its own does not allocate resources efficiently in a way that balances social costs and benefits; externalities are one example of a market failure

negative externality

a situation where a third party, outside the transaction, suffers from a market transaction by others

positive externality

a situation where a third party, outside the transaction, benefits from a market transaction by others

social costs

costs that include both the private costs incurred by firms and also additional costs incurred by third parties outside the production process, like costs of pollution

spillover

see externality

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