Arthur Cecil Pigou (1877-1959) developed earlier work by fellow English economists HENRY SIDGWICK (1838-1900) and Alfred Marshall (1842-1924) into an important feature of modern economic theory.
Economic activity generates costs and benefits, some of which are not incurred/enjoyed by the person performing the activity.
When, for example, a company pollutes the environment, it may enjoy efficient production yet society is faced with the cost of the pollution. (Acid rain is a large-scale example of this.)
Similarly, a firm that trains its workers well will lose some of this benefit when the worker moves to another firm, in which case society as a whole benefits.
Also see: cost-benefit analysis, consumer surplus, compensation principle, coase theorem, social welfare function
A C Pigou, Economics of Welfare (London, 1920)
In economics, an externality is a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit. The concept of externality was first developed by economist Arthur Pigou in the 1920s. Air pollution from motor vehicles is an example of a negative externality. The costs of the air pollution for the rest of society is not compensated for by either the producers or users of motorized transport.
The prototypical example of a negative externality is environmental pollution. Pigou argued that a tax (later called a “Pigouvian tax”) on negative externalities could be used to reduce their incidence to an efficient level. Subsequent thinkers have debated whether it is preferable to tax or to regulate negative externalities, the optimally efficient level of the Pigouvian taxation, and what factors cause or exacerbate negative externalities, such as providing investors in corporations with limited liability for harms committed by the corporation.
Externalities often occur when the production or consumption of a product or service’s private price equilibrium cannot reflect the true costs or benefits of that product or service for society as a whole. This causes the externality competitive equilibrium to not adhere to the condition of Pareto optimality. Thus, since resources can be better allocated, externalities are an example of market failure.
Externalities can be either positive or negative. Governments and institutions often take actions to internalize externalities, thus market-priced transactions can incorporate all the benefits and costs associated with transactions between economic agents. The most common way this is done is by imposing taxes on the producers of this externality. This is usually done similar to a quote where there is no tax imposed and then once the externality reaches a certain point there is a very high tax imposed. However, since regulators do not always have all the information on the externality it can be difficult to impose the right tax. Once the externality is internalized through imposing a tax the competitive equilibrium is now Pareto optimal.
For example, manufacturing activities that cause air pollution impose health and clean-up costs on the whole society, whereas the neighbors of individuals who choose to fire-proof their homes may benefit from a reduced risk of a fire spreading to their own houses. If external costs exist, such as pollution, the producer may choose to produce more of the product than would be produced if the producer were required to pay all associated environmental costs. Because responsibility or consequence for self-directed action lies partly outside the self, an element of externalization is involved. If there are external benefits, such as in public safety, less of the good may be produced than would be the case if the producer were to receive payment for the external benefits to others. For the purpose of these statements, overall cost and benefit to society is defined as the sum of the imputed monetary value of benefits and costs to all parties involved