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What are Externalities | Meaning, Effects & Internalization

This article is divided into 3 parts. The first part deals with different types of externalities, second part depicts its important role in environment and in third part various kinds of solutions to these externalities are demonstrated.

A few minds can’t get head and tails about the term ‘Externalities’. So at the outset one must have a clear understanding of what are these externalities? An Externality is a profit or loss, stemmed from either the production or consumption of a good or service, incurred to a third party outside the market mechanism rather than the entity that causes it and this is why it is playing a crucial role in modern social-economics and environment. Here the producer and buyer are the first and second parties and the third parties include any individual, an organisation, a society or a resource that is indirectly affected.

Externalities Meaning, Effects & Internalization

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Types of Externalities

Generally, there exist only two types of externalities-positive and negative.

Positive Externality

Positive externalities are unpaid benefits obtained by an individual or social that refers to the society as a whole. These individuals or groups that get the advantages without any contributions are called ‘Free Riders’. One can divide these positive externalities in 2 ways.

Positive Externalities of Production 

Positive externalities which influence the possibilities of production for a third party are called positive externalities of production. For examples, suppose a person plants some trees in the courtyard of his house. The whole neighbourhood will cherish its amenities. Or, a company that develops any new social-friendly technology mostly help the common.

Positive Externalities of Consumption

Positive externalities which influence the possibilities of consumption for a third party are called positive externalities of consumption. This means that the social benefits of consumption exceed the private benefits.

Investment in education benefits the individual as well as the whole. It increases one’s personal knowledge and decreases illiteracy of a community , also reduces un-employment. So a little consumption metaphors into a great advantage.

At the time of a pandemic crisis if vaccines of the virus can be created, it not only cures a person vaccinated but also decreases the number of the infected ones globally which indeed is deemed as a positive externality.

Another example can be seemed as the street lights help the passer-by to walk on the streets easily.

Negative Externality

Negative externalities are the costs experienced by a third party due to some activities. Externalities have negative consequences when the aggregate social cost overweighs the private cost. Most of the  externalities fall in this category. Pollution is a very well-known negative externality in environment. These can also be distinguished in 2 types.

Negative Externalities of Production

Negative externality which influence the possibilities of production of a third party is called Negative externality of production. Some examples are as below:

A factory throws its sewage wastages in the nearby river which ruins both the aquatic livelihood and the surrounding living people who use the water in their daily necessities.

People living near a railway station suffers due to noise pollution.

Negative Externalities of Consumption

Negative externalities which influence the possibilities of consumption of a third party is called Negative externality of consumption.

A factory burns its rubbishes emerging smokes which leads to air pollution and also deteriorate public health.

If one drinks excessive alcohol, he may react outrageously and which disturbs the surrounding ones. This can be regarded as a negative externality.

An individual is playing loud music in his house. Though he is enjoying it, this causes disturbance to whole neighbours and reduces their benefit of owning the house and living in it, at the worst it may affect the weak health too.

Effects of Externalities

Other than the environment, externalities have a more or less impact in economics, sociology and other social sciences. Externalities are often considered as ‘market failure’. For the negative externalities the producer does not borne all the costs resulting excess production and in case of positive externalities the buyer can’t enjoy all the benefits of the good resulting decreased production. Also externalities have a great effect on the society-either the health issues, education or people’s daily livelihood. But in modern days the most crucial part is the environment. People are jeopardizing the environment for the satisfaction of their own selfishness. Environmental externalities refer to the uncompensated environmental effects of production and consumption of a good. Selfishness leads market to produce whatever people want and sell what people are eager to buy and which pushes forward the environment to the destination of annihilation. It is often said that “ clean air has positive externalities and so clean air is underproduced” and on the contrary “dirty air has negative externalities and so dirty air is overproduced”. Hence the environmental externalities must be dealt with vigilant.

Related: How Plastic Pollution May Be Impacting Your Health, How Urban Economics drive Economic Development

Internalization of Externalities 

Due to the malignant effect of both positive and negative externalities on market prices, society and environment the internalization of the externalities is inexorable. These are the procedures of imposing some policies generally initiated by the government to control the impact of externalities on unrelated parties. The solutions to overcome the negative effects of externalities include the followings.

  1. Extending Property Right can be one such solution so that the third party that is mostly affected by the production or consumption can negotiate with those individuals or organisations which causes the externality. Thus to get rid of the disputes the producer or the buyer must follow some methods to take into account the externalities.
  2. There exists some limitation to property rights such as the sea, air or the road that can’t be owned by an individual or a group. There come some other processes. One method is taxes. British economist Arthur C. Pigou first suggested that the Government could impose taxes on the good and services that cause externality. The taxation encourage the reduction of market outcome of the externality to an extent and eventually discourage the activities that affect an unrelated third party. These taxes are known as Pigovian Taxes which appease the negative externality.
  3. Another way is Subsidising. Government can also impose subsidies motivating the consumption of a positive externality. Some people call these Pigovian Subsidies.
  4. Implementing Regulation turns out to be the most common solution. Government has passed many environmental and some other regulations to restrict the production or consumption of these externalities.
  5. The people who causes the externalities can be compelled to pay the Compensation to the third party who suffers due to this process. This may lead to a fruitful result.
  6. Spreading Awareness among people specially the producer or the buyer about the consequences of these externalities both on their environment and their own business can be beneficial.
  7. There are also some other methods which are profitable and stable such as Road Pricing Schemes, Cap and Trade or Individual Transferable Quotas (ITQs) .


These positive and negative environmental externalities prevail in many areas of environment such as environment politics, social environment and so on. But for the  protection and welfare of environment there are numerous contrivances to prevent its negative consequences. Above all increasing public consciousness about the lethal negative effects of the externalities is the best avenue to cope with this present situation.

Author Bio:  Goutami Sadhukhan, pursuing B.Sc.(Honours) in Mathematics at St. Xavier’s College(Autonomous),Kolkata.


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