What is an Externality?

“British economist A.C. Pigou was instrumental in developing the theory of externalities. The theory examines cases where some of the costs or benefits of activities ‘spill over’ onto third parties. When it is a cost that is imposed on third parties, it is called a negative externality. When third parties benefit from an activity in which they are not directly involved, the benefit is called a positive externality. …

Pigou recommended taxing [or regulating] activities that produce negative externalities. Emission taxes on factories are an example of this approach. ,,, The traditional policy responses to positive externalities have been for the state to subsidize or require the activities in question. For example, the US government subsidizes research into alternate energy sources. …

The free market is not a panacea. It does not eliminate old age, and it won’t guarantee you a date for Saturday night. Private enterprise is fully capable of awful screwups. Both theory and practice indicate that its screwups are less pervasive and more easily corrected than those of government [interventions].”

Originally published here at the Mises Institute on 1 August 2001.

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