What, Exactly, Are Negative Externalities? (Donald J. Boudreaux, 2/5/25, AIER)
By far, the market imperfection believed, at least by economists, to be most common is that of externalities. An externality, as defined by the Nobel-laureate economist George Stigler, “is an effect, whether beneficial or harmful, upon a person who was not a party to the decision.” Consult almost any economics textbook and you discover a similar definition of externality. Because harmful effects of this sort (“negative externalities”) generally get more attention than do beneficial effects (“positive externalities”), the discussion in this Explainer will be confined to negative externalities, although most of the points I make apply also to positive externalities.
A classic example of a negative externality is a railroad that builds a line next to farmland and, when it runs its trains, throws sparks onto the farmland, occasionally burning the farmer’s crops. The farmer suffers damage that he did not bargain for. If the railroad doesn’t pay for this damage, it does not cover all of its operating costs, which include doing damage to crops. Because incurring costs restrains the actions that generate the costs, not having to pay all of its costs leads the railroad to run too many trains. And when the railroad runs too many trains, the farmer winds up supplying too few crops.
To induce the railroad to produce the optimal amount of railroad services, it must somehow be obliged to pay not just for some of its costs of doing business—to pay not just wages to compensate its workers, and prices to compensate its suppliers of fuel—but to pay for all of its costs, including whatever damage it causes to farmers and other parties who suffer incidental losses as a result of the railroad’s operation.
A.C. Pigou and Ronald Coase
The government can “correct” this market imperfection by imposing on the railroad a tax equal to the value of the crops damaged by its trains. This tax—called by economists a “Pigouvian tax” (after the British economist A.C. Pigou)—“internalizes” on the railroad the cost that it once imposed on the farmer. A cost that was previously external to the railroad’s decision-making processes is now internal to it given that the railroad must pay the tax. With this cost “internalized” on the railroad, it will now produce the economically optimal amount of railroad services, and allow the farmer to supply the optimal amount of crops.