What is a negative externality and how can you address them?

An externality is a benefit or a cost borne by a third party when producing or consuming a good. Hence there can be negative and positive externalities of production and consumption. E.g. Cigarettes have a negative externality of consumption, as they diminish air quality for other people who are not smoking. Typically, a negative externality is overconsumed whereas a positive externality (e.g. education) is under-consumed, which leads to a situation of market failure. In the case of demerit goods (those that have a negative externality), government intervention i.e. taxes can help reduce the external cost generated by the firm, as these would increase production costs and prices, which would induce the firm to reduce output levels closer to an optimum quantity. However, it is difficult to completely eliminate market failure as it is arduous to estimate the size of the tax needed to reach an optimum quantity. Price elasticity would also play a role. In the case of price inelastic demand, a tax may not be sufficient to reduce demand. Banning advertising, moral persuasion and education may also help reduce market failure by attempting to change consumer practices and consumption patterns by increasing awareness of the external costs of certain products. Ads for cigarettes, for example, have long been banned and in their packaging typically depicts the negative effects of smoking on the consumers' health to attempt to reduce consumption. Governments may also directly regulate the consumption of a demerit good. E.g. Cigarettes can only be sold to people above a certain age and the ban on indoor smoking regulates consumption.


Other potential solutions for negative externalities include legislation to ban the product or to set quotas or other standards, e.g.  environmental standards for the production of cars. Another specific way to address a production negative externality is by issuing tradable emission permits, whereby firms are allowed to produce a fixed amount of pollution, which are also tradable in the free market. These incentivise firms to reduce pollution (one of the most common and predominant negative externalities in most industries) and thus may help reduce market failure.