Externality

Definition

An externality in finance refers to the indirect impact of an economic activity on parties that did not choose to be involved in that activity. It can be either positive when the effect is beneficial, or negative when the effect is harmful. These are also known as spill over effects and can have significant implications on market outcomes and resource allocation.

Phonetic

The phonetics for the word “Externality” is: /ˌekstərˈnalətē/

Key Takeaways

1. Definition: Externality refers to the economic concept of incurring an indirect cost or benefit to individuals or parties who aren’t directly involved in a transaction or business activity.
2. Types of Externality: Externality can be broken down into two categories – positive and negative. Positive externalities result in beneficial effects for third parties, while negative externalities bring about harmful consequences.
3. Effect on Society: Externalities can have significant impacts on society. In cases where these impacts are negative, governments may step in with regulations or taxes to try and ‘internalise’ these external costs.

Importance

The term “externality” is important in business and finance as it refers to the indirect impact of an individual’s or company’s actions on the well-being of a third party. These actions can either positively or negatively affect others who did not choose to be involved in the situation. Positive externalities can include things like improved public health due to a company’s investment in pollution reduction. Negative externalities could be environmental damage caused by business operations. Understanding and considering these external effects is essential in making business decisions, policy setting, and in mitigating potential harms or enhancing potential benefits to society at large. It helps to ensure that all costs and benefits are accurately accounted for in economic analysis and policy-making.

Explanation

Externality serves as a vital concept in finance and business, referring to the impact of an economic activity that reaps collateral effects impacting third parties or the wider economy. These ramifications can be beneficial (positive externalities) or detrimental (negative externalities), and theparties causing these effects often do not consider them when making decisions. For instance, a company might manufacture products that create pollution (a negative externality), affecting the atmosphere and health of the community, while a firm training its personnel may result in these employees using their skills elsewhere in the sector (a positive externality). Thus, the overall purpose of externalities is to illustrate the vast range of unseen effects that business operations can have on the economy and society at large. Highlighting the existence of externalities allows economists and policymakers to advocate for regulations or interventions that can curb negative externalities or foster positive ones. For example, in the case of a harmful externality, like pollution, regulations or ‘Pigouvian taxes’ may be implemented to limit the effect and ensure that the impacting party accounts for the full social cost. On the other hand, when beneficial externalities such as education are produced, subsidies or grants can be introduced to encourage more of these positive activities. Essentially, the acknowledgment and understanding of externalities assist in facilitating a more comprehensive and balanced approach to finance and business decision-making, incorporating societal impacts and not just direct costs or benefits.

Examples

1. Pollution: A classical example of an externality is the pollution emitted by a factory. While the business may benefit from manufacturing products, the surrounding environment and community are affected by the pollution generated. This can lead to health issues among community members, or the damaging of the local ecosystem, which won’t necessarily be factored into the business’s costs. This effect on others is considered a negative externality. 2. Public Transportation Upgrades: An example of a positive externality is when a city invests in upgrading its public transportation system. The direct benefits include increased efficiency and lower operating costs for the public transport authority. However, external benefits could include less congestion on roads due to more people opting for public transit, lower emission levels, and reduced travel times, all of which benefit the society but aren’t necessarily factored into the calculations of the transportation entity making the upgrades. 3. Secondhand Smoke: If a person decides to smoke in a public area, they personally enjoy the benefits of smoking, but they are imposing a cost on others via secondhand smoke. This is a classic example of a negative externality because the smoker is not taking into account the harm inflicted on others when making the decision to smoke.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Market Failure
• Public Goods
• Private Cost
• Social Cost
• Positive Externality

Sources for More Information

• Investopedia
• International Monetary Fund
• Corporate Finance Institute
• Wikipedia