What Are Production Externalities?
Let me explain production externalities directly to you: they refer to side effects from an industrial operation, like a paper mill dumping waste into a river. These are usually unintended, and their impacts are unrelated to and unsolicited by anyone involved. They can lead to economic, social, or environmental side effects.
You can measure production externalities by looking at the difference between the actual cost of producing a good and the real cost this production imposes on society as a whole. The impacts can be positive, negative, or even a mix of both.
Key Takeaways
Here's what you need to grasp: production externality is a side effect from an industrial operation, such as a chemical company leaking improperly stored chemicals into the water table. You measure them by the difference between the actual production cost and the real cost to society. Their impact can be positive, negative, or a combination. A positive production externality imposes a positive effect on an unrelated third party, while a negative one does the opposite.
Understanding Production Externalities
There are plenty of examples of production externalities, including pollution and the depletion of natural resources. Consider a logging company: they might pay for removing a single tree, but replacing an entire forest once it's gone costs far more than just the sum of those trees. Other instances include freeway traffic jams or health issues from breathing secondhand smoke—these are clear externalities in production. A major case is the Flint water crisis in 2019, which showed a large-scale negative production externality.
The British economist A.C. Pigou was the first to point out production externalities as a systemic issue. He argued that when externalities exist, we don't reach Pareto optimality, even in perfect competition. With externalities present, the social benefit or cost becomes a mix of private and external benefits or costs.
Examples of Positive Production Externalities
A positive production externality, also known as an external benefit or beneficial externality, is the positive effect an activity has on an unrelated third party—much like a negative one but in the opposite direction.
Take the farmer who keeps bees for honey: a side effect is the pollination of surrounding crops by those bees, and the value from that pollination might exceed the value of the honey itself. Another case is building and operating an airport, which benefits local businesses through better accessibility. Or consider an industrial company offering first aid classes to employees for workplace safety—this could save lives beyond the factory. Finally, a foreign firm might demonstrate advanced technologies to local firms, boosting their productivity.
Examples of Negative Production Externalities
On the flip side, a negative production externality is the negative effect an activity imposes on an unrelated third party.
Think of noise pollution from someone blasting loud music in an apartment building, causing sleep deprivation for neighbors. Or the increased use of antibiotics leading to more antibiotic-resistant infections. Another example is the development of health issues like early-onset Type II diabetes and metabolic syndrome from companies over-processing foods, especially by removing fiber and adding sugars.
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