Externalities are the benefits or costs that arise when the decision to consume or to produce generates some positive or negative impact on the environment affecting the welfare of others in a way that is not transmitted through prices or via market mechanisms. When the market price does not truly reflect the real price in which the externality should be considered, there is a loss of efficiency.
As previously stated, it is important to have in mind that externalities can be linked both to an improvement of the utility for individuals but also to its damage. The former are known as positive externalities and an example of one would be the vaccination of an individual that would prevent having a disease and at the same time avoid the spread of the disease to others. On the other hand negative externalities are those that reduce utility and a common example is the air pollution produced by many factories.
The diagram below shows the graphical representation of a negative externality problem using a polluting factory as an example. The horizontal axis or x-axis measures the amount of output produced by the polluting factory and the vertical axis or the y-axis measures monetary units. The marginal benefit curve (MB) represents the marginal benefit of the factory for each level of production which declines as the amount of output increases. The marginal private cost curve (MPC) shows the marginal cost of the factory as output rises. The more the factory produces, the more it pollutes and hence the bigger the negative effects, which is represented by the marginal damage curve (MD). Lastly, the marginal social cost (MSC) represents the total marginal cost for the whole society, and is constructed by adding together the private costs (which directly translate to higher prices) and social costs.
The socially efficient output QS in this case is located at a lower quantity and at a higher price than the actual output QA. Whenever market mechanisms do not properly transmit price there will be a loss of efficiency. If it were a positive externality being produced, the opposite would not necessarily occur. It is true that the optimum social would be to set a higher output but price could be lower, equal or even higher than the private optimum depending on the location and slope of the curves.
Several solutions have been proposed in order to reduce inefficiencies created by externalities:
Pigouvian tax: this corrective tax is levied on each unit of output an externality-generator agent produces. This tax is equal to the marginal damage at the efficient level of output (t on the adjacent diagram).
Subsidies: in a polluting industry, firms are paid not to pollute (the government pays a subsidy equal to s, the green rectangle). This method works in a similar way to a tax but this time the government spends money instead of collecting it, while it is the other way for firms.
Cap-and-trade: the basic idea behind this measure is to create a market, where there are a limited number of pollution permits, which allows the firms that pollute less to sell the permits they do not use to other firms that pollute more. This system of tradable pollutions permits will benefit low pollutant firms and penalize high pollutant ones.