production externalities

What is a production externality?

Production externalities refer to the side effects of industrial operations, such as waste produced by a paper mill being dumped into a river. Production externalities are usually unexpected, and their effects are usually unrelated to and unsolicited by anyone. They may have economic, social or environmental side effects.

Production externalities can be measured as the difference between the actual cost of producing a good and the actual cost of that production to society as a whole. The effects of production externalities can be positive, negative, or both.

key takeaways

  • Production externalities are side effects of industrial operations, such as chemical companies leaking improperly stored chemicals into the water table.
  • Production externalities can be measured in terms of the difference between the actual production cost of goods and the actual cost of society as a whole.
  • The effects of production externalities can be positive, negative, or both.
  • A positive production externality is the positive effect an activity has on an unrelated third party; a negative externality is the negative effect an activity exerts on it.

Understanding production externalities

There are many examples of production externalities, such as pollution and the depletion of natural resources.

Logging companies can pay them to remove a single tree, but once the forest is gone, the cost of replacing the entire forest is much more than the sum of its lost trees. Highway traffic congestion and health problems caused by breathing secondhand smoke are further examples of externalities in production. A striking example of a large ecosystem with negative production externalities is the 2019 Flint water crisis.

British economist AC Pigou was the first to call production externalities a systemic phenomenon. Pigou argues that in the presence of externalities, we cannot achieve Pareto optimality, even in perfect competition. If there is an externality, the resulting social benefit or cost becomes a combination of private benefit and external benefit or cost.

Examples of Positive Production Externalities

A positive production externality (also called an “external benefit” or “external economy” or “beneficial externality”) is the positive effect of an activity on unrelated third parties. Similar to negative externalities.

Return to the example of farmers keeping bees for honey. A side effect or externality associated with such activities is the pollination of surrounding crops by bees. The value generated by pollination may be more important than the actual value of harvested honey.

  • The construction and operation of the airport will benefit local businesses due to its convenient transportation.
  • An industrial company offering first aid courses to employees to improve workplace safety. It can also save lives outside the factory.
  • A foreign company that showcases the latest technology to local companies and increases their productivity.

Examples of Negative Production Externalities

Likewise, a negative production externality is the negative impact of an activity on an unrelated third party.

  • Noise pollution from someone playing loud music in an apartment building can cause sleep deprivation in neighbors.
  • Increased use of antibiotics can spread an increase in antibiotic-resistant infections.
  • The development of ill health, especially early-onset type 2 diabetes and metabolic syndrome, due to the company’s excessively processed foods (mainly to remove fiber and added sugars).

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