How do externalities affect the economy?

Answer 1

I love that word. It's really a term of art, a bit of jargon, from the economics world. Few people have HEARD the word, let alone know what it means. Your question is a a simple one, but will require thousands of words to answer, so hopefully, people will contribute to this answer and grow it into something worthwhile. I guess we could start with a definition of externality. In this context it is an incidental condition that may affect a course of action, but that doesn't really help people unfamiliar with the word to grasp its meaning in the realm of economics. In economics an externality is a cost associated with a particular activity but not adequately considered (at least at first) when calculating the costs of providing or engaging in that activity. Those costs are frequently borne not just by the people who benefit from that economic activity -- the producers and consumers -- but by everyone, or nearly everyone, even people not directly involved in the activity. Perhaps it's best to provide an example or two. If a factory produces and sells chemicals, the factory profits from the sale of those chemicals, and the consumers of the chemicals also benefit from them; otherwise why would they purchase them? There are costs associated with producing the chemicals, costs that will be borne by the producer and, to a degree, by consumers, as part of the price they pay. But let's say that the process of producing the chemicals creates waste products that are either dumped into the ground or water supply or pumped into the air. All of society pays a cost in the form of a degraded environment, reduced supply of drinkable water, worsened health, increased health-care, perhaps even shortened life spans. That pollution is an externality. If the cost of that externality is not monetized some way, if the cost is allowed to be borne by thousands, if not millions, of people who aren't benefiting directly from the production of the chemicals, then those chemicals may be overproduced, because the true cost of producing them is not reflected in the price, which leads to increased demand for it.