The meaning of externalities
Vinod Anand | 16 Feb 2012

Externalities in consumption exist when the level of consumption of some good or service by one consumer has a direct effect on the welfare of another consumer, as opposed to an indirect effect through the price mechanism (note 'goods' are defined very broadly to include anything which yields utility.

PRODUCTION EXTERNALITIES exist when the production activities of one firm directly affect the production activities of another firm are therefore particular cases of externalities in production. Examples of consumption externalities are: A, wanting privacy, builds a high fence, which reduces the amount of sunshine flooding in through B's window.A, in making a right turn on a busy two-way road, causes a large traffic jam to build up behind him.Miss A wears a miniskirt.Examples of production externalities are:Firm A discharges effluent into a river, which greatly increases costs of Firm B downstream.

Firm A set up a training school for computer programmers, which increases the availability of programmers to Firm B. There may also, of course, be mixed production/consumption externalities. For example:Night flights by jet airliners may cause residents in areas close to an airport to lose sleep, and hence adversely affect their work. Holiday motorists may increase congestion on a road, and hence increase costs of road-haulage firms. The essence of externalities, whether in production or consumption, is that their costs or benefits are not reflected in market prices, and so the decision of the consumer or firm creating the externalities on the scale of the externality-creating activity generals does not take its effect into account.

Hence, since the time of A. C. Pigou, economists have argued that social welfare would be increased if the private consumption or production decision were modified so as to take the external effect into account. The means of doing this were traditionally held to be the imposition of taxes on activities which created losses in welfare or increases in costs, and payment of subsidies on activities which increased welfare or lowered costs. In practice, tax-subsidy schemes are rarely adopted. More frequently, externalities are uncorrected, or absolutely prohibited - right turns in certain streets, smoking in certain railway compartments - or property rights are created and redress is possible through the courts, e.g. the common law 'right to lights'. For certain types of externalities (proximity to an abattoir, or to an airport), compensation might be paid, either directly, or through reductions in rates.