Subject: Micro Economics Topics: Externalities & Their Effects Submitted To: Dr. M. Ahsan Zia Submitted By: Abid Ali Roll No: B-23442

Subject: Micro Economics
Topics: Externalities & their effects

Submitted to: Dr. M. Ahsan Zia
Submitted by: Abid Ali
Roll No: B-23442
University of South Asia Raiwind Road

Externality
An externality is a cost or benefit of an economic activity experienced by an
unrelated third party. The external cost or benefit is not reflected in the final
cost or benefit of a good or service. Therefore, economists generally view
externalities as a serious problem that makes markets inefficient, leading to
market failures. The externalities are the main catalysts that lead to the
tragedy of the commons.
Types of Externalities
Generally, externalities are categorized as either negative or positive.
1. Negative externality
A negative externality is a negative consequence of an economic activity
experienced by an unrelated third party. The majority of externalities are
negative. Some negative externalities, such as the different kinds of
environmental pollution, are especially harmful due to their significant
adverse effects. Negative externalities are divided into production and
consumption externalities.
Examples of negative production externalities include:
 Air pollution: A factory burns fossil fuels to produce goods. The

people living in the nearby area and the workers of the factory suffer
from the deteriorating air quality.
 Water pollution: a tanker spills oil, destroying the wildlife in the sea
and affecting the people living in coastal areas.
 Noise pollution: People living near a large airport suffer from high
noise levels.

Some examples of negative consumption externalities are:
 Passive smoking: Smoking results in negative effects not only on the

health of a smoker but on the health of other people.
 Traffic congestion: The more people use roads, the heavier the traffic
congestions are.
2. Positive externality

Positive externality is a benefit from an economic activity experienced by an
unrelated third party. Despite the benefits of economic activities that involve
positive externalities, the externality also creates market inefficiencies.
Positive externalities can also be distinguished as production and
consumption externalities.
Positive production externalities include:
 Infrastructure development: Building a subway station in a remote

neighborhood may benefit real estate agents who manage the
properties in the area. Real estate prices would likely increase due to
better accessibility, and the agents would be able to earn higher
commissions.
 R&D activities: A company that discovers a new technology as a
result of research and development (R&D) activities creates benefits
that help the society as a whole.
Examples of positive consumption externalities are:

 Individual education: The increased levels of an individual’s
education can also raise economic productivity and reduce
unemployment levels.
 Vaccination: Benefits not only a person vaccinated but other people
as well because the probability of being infected decreases.
Solutions to Externalities
Due to the adverse effect of both negative and positive externalities on
market efficiency, economists and policymakers intend to address the
problem. The “internalization” of the externalities is the process of adopting
policies that would limit the effect of the externalities on unrelated parties.
Generally, the internalization is achieved through government intervention.
Possible solutions include the following:
1. Defining property rights

The stricter definition of property rights can limit the influence of economic
activities on unrelated parties. However, it is not always a viable option since
the ownership of particular things such as air or water cannot be
unambiguously assigned to a particular agent.
2. Taxes
A government may impose taxes on goods or services that create
externalities. The taxes would discourage activities that impose costs on
unrelated parties.

3. Subsidies
A government can also provide subsidies to stimulate certain activities. The
subsidies are commonly used to increase the consumption of goods with
positive externalities.
Additional Resources
CFI is the official provider of the global Financial Modeling & Valuation
Analyst (FMVA)™ certification program, designed to help anyone become a
world-class financial analyst. To keep advancing your career, the additional
CFI resources below will be useful:
 Invisible Hand
 Network Effect
 Normative Economics
 Pareto Efficiency

Subject: Micro Economics Topics: Externalities & Their Effects Submitted To: Dr. M. Ahsan Zia Submitted By: Abid Ali Roll No: B-23442

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Subject: Micro Economics Topics: Externalities & Their Effects Submitted To: Dr. M. Ahsan Zia Submitted By: Abid Ali Roll No: B-23442

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Subject: Micro Economics

Topics: Externalities & their effects

University of South Asia Raiwind Road

Examples of negative production externalities include:

 Air pollution: A factory burns fossil fuels to produce goods. The

Some examples of negative consumption externalities are:

 Passive smoking: Smoking results in negative effects not only on the

2. Positive externality

Positive production externalities include:

 Infrastructure development: Building a subway station in a remote

Examples of positive consumption externalities are:

1. Defining property rights

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