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Externalities refer to transactions that exist between parties where either party imposes a cost or confers benefits on a third party and there is no feasible way of compensating the effected party. They are the impact of one person’s actions on the well being of another.

Externalities can be classified into two distinct groups positive and negative. Positive externalities as the name suggests creates a beneficial effect on bystanders. A negative externality creates an adverse effect on bystanders. There are many examples of externalities in the world we live in. These include pollution as a result from car emissions (negative externality), historic building restoration (positive externality).

In terms of production, negative externalities will force social costs to exceed private costs. This subsequently makes the socially desirable quantity smaller than the equilibrium. When the production of a good is being researched a “planner” is appointed to maximise surplus. The point at which the company can commence production is when the demand curve crosses the social-cost curve. If the company produced below the optimal level, then the value of the additional product is greater than the social cost of producing the product. If the company produced above the optimal level, then social costs of producing the additional product exceed value to consumers.

There are numerous ways a planner can achieve the optimum level. For negative externalities, a tax could be imposed on producers requiring them to pay $x amount of dollars for each tonne/packages sold. This is referred to as internalising the externality. Internalising an externality can be defined as altering incentives so that people take into account the external effects of their actions. That is, it provides buyers and sellers with the opportunity of incentives to take into account the external effects of their actions. For positive externalities, the government can subsidise the production of goods. If the government decided to pay for every product produced by the sole manufacturer, this shifts the supply curve downwards by the amount of the subsidy and thus increases the equilibrium quantity of the product. To ensure that market equilibrium equals the social optimum, the subsidy should equal the value of the technology spill over.

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