Externalities, external effects

Economic acts (e.g. consumption, production, cartel agreements) can affect uninvolved third parties. Depending on whether these consequences are beneficial or reducing, we speak of positive or negative external effects. Examples of positive external effects would be the costly renovation of a listed building that also benefits neighbours by offering a more attractive view, or research activities whose results can be used by the general public. Negative external effects occur, for example, in the production of electricity from coal, as the associated air pollution and CO2 emissions have a negative impact on the health of the population and on the greenhouse effect. Noise pollution from airplanes or from practicing a loud musical instrument are also examples of negative external effects.

Since the external effects are not taken into account in the cost-benefit considerations of the polluter, suboptimal decisions or market failures usually result.

In particular, governmental regulations or institutions can attempt to remedy this by internalising negative external effects, i.e. assigning them to the polluter. Mineral oil taxes or trading in CO2 emission rights are measures that make environmental pollution more expensive for the polluters and thus at least partially internalise external effects. Another possibility is the (limited) prohibition of measures that lead to negative external effects. Examples would be the establishment of rest periods during which no loud music may be played or a ban on ozone-depleting CFCs in refrigerators.

Positive externalities can lead to the undesirably low availability of the relevant goods, as the polluter bears the full costs but does not reap the full benefits. This can be countered by promotional measures, such as improved depreciation of renovation costs of listed buildings or patent protection for inventions.