Externality of Production

Definition

An externality of production refers to the indirect effect, either positive or negative, that production processes have on third parties or the environment which is not reflected in the market price. It happens when the costs or benefits of a production process are not fully borne or enjoyed by the producer. Examples can include pollution from factories which has health impacts on local communities or job creation in local economies.

Phonetic

The phonetics of the keyword “Externality of Production” is: ɛks-tər-năl′ĭ-tē ŏv prŏ-dŭk′shən.

Key Takeaways

1. Nature of Externality: Externality of production refers to the effect of production processes on third parties which are not directly involved in the production or consumption of the goods or services. They can be positive (beneficial effects) or negative (harmful effects).
2. Impact on Society: Negative externalities of production, like pollution, can have sever impacts on society and the environment. They often lead to market failure, as the market does not naturally account for these social costs. Positive externalities, on the other hand, can be beneficial to third parties, such as technological advancements that can spur economic growth.
3. Government intervention: Often, government intervention is required to correct the externalities. This can be in the form of regulation, taxes, subsidies, and property rights. The aim is to ensure the producers consider the full cost of their production, not just the private costs.

Importance

The term “Externality of Production” is important in business/finance because it refers to the costs or benefits that affect a party who did not choose to incur those costs or benefits. These impacts, which can be either positive or negative, often stem from industrial processes and can extend to society and the environment, impacting the overall economy. For instance, a company may produce pollution (a negative externality) that negatively affects the local community or ecological health, or a company could stimulate local economic growth (a positive externality) through new jobs and increased consumer spending. Both scenarios have financial implications for stakeholders, communities, and country economies. Understanding these externalities helps policymakers design efficient regulations, aids businesses in accounting for social costs/benefits, and allows for more comprehensive economic analyses.

Explanation

Externality of Production is an economic concept that refers to the unintentional effects of a production process that are not directly reflected in the costs of goods or services, and hence are not borne by the companies involved in production. These effects could be good or bad and invariably impact the society or environment when a product or service is produced. This concept serves as a crucial point of deliberation for policymakers, analysts, businesses, and researchers because it can have enduring implications on societal welfare, business profit margins, and overall market efficiency. The purpose of analyzing externalities of production is to align the interests of the firms with those of the broader society. Usually, negative externalities, such as air or water pollution, are omitted from a firm’s cost calculation leading to overproduction and underpricing of goods causing social harm. By identifying these unseen costs, policymakers can impose regulations or taxes – also known as Pigovian taxes – to incorporate these external costs into direct production costs, leading to more responsibly priced products. On the other hand, positive externalities lead to underproduction, so subsidies or incentives may be provided to promote these beneficial activities. Moreover, evaluating externalities is a pre-requisite for effective corporate sustainability practices, helping businesses to quantify, monitor, and reduce their environmental footprints. Thus, the concept of ‘Externality of Production’ is used to blend the goals of economic development with environmental preservation.

Examples

1. Pollution: A classic example of an externality of production is pollution. When factories produce goods, they often also produce harmful byproducts like air and water pollution. These pollutants can have severe negative impacts on the environment and public health. However, the cost of these damages is not typically borne by the factory owners. Instead, it’s indirectly paid for by the general public in the form of healthcare expenses or environmental cleanups. 2. Noise Pollution: Another example could be noise pollution caused by construction companies. When a construction company builds a new project, the local community has to deal with the noise generated by the construction works. This noise pollution can disrupt everyday activities and lead to stress and health issues in the long term. The cost of these health issues are external to the construction company. 3. Increased Road Traffic: A company may open a new store or factory in a neighborhood, leading to an increase in traffic in that area due to new customers or employees commuting. This increased road usage can lead to congestion and longer travel times for other road users, as well as increased wear and tear on the roads. This cost is external to the company, but it significantly affects the residents and regular commuters in the area.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Cost-Benefit Analysis
• Market Failure
• Public Goods
• Negative Externalities
• Private and Social Costs

Sources for More Information

• Investopedia
• Corporate Finance Institute
• WallStreetMojo
• Indeed