Economic Externalities

Positive and Negative External Effects of Economic Activities

An Article in the Compendium of Market-Based Social-Ecological Economics


Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version: Wirtschaftliche Externalitäten

Table of Contents

  1. Abstract
  2. Definition of Terms
  3. External Effects Conducive to Competition (Category 1)
  4. External Effects Distortive on Competition (Category 2)
  5. Examples of Distortive External Effects (Category 2)
  6. Scope of Distortive External Effects (Category 2)
  7. Methods of Internalization (Category 2)
    > Systemic, Permanent Internalizations
    > Selective and Temporary Internalizations
    > Other Methods of Internalization


Externalities are side effects of economic activities that transfer unjustified benefits (profits) or costs to uninvolved third parties. The main topics of criticism are external costs caused by wage and price dumping that result in market failure. It’s a central responsibility of economic policy to avoid externalities through appropriate measures from the outset, that is, to internalize external benefits and costs.

2. Definition of Terms

ExternalitätenJPG03The term externalities stands for external effects emanating from individual economic activities of production and consumption, activities whose consequences are directed towards third parties or the general public without direct relationships between perpetrators and parties affected. It is essential to distinguish between positive and negative external effects.

Positive external effects will not be reimbursed to the perpetrators and provide external parties with unexpected benefits. Negative external effects are not charged to the perpetrators and provide external parties with unjustified costs. That is, externalized costs cause external damage, as shown in the above figure.

In a market economy the pricing of a product ideally results from its production costs and the benefits it creates from usage or consumption. External costs, which are the primary concern here, will always arise when producers, due to poor economic policy, enjoy the freedom to only consider their own operational costs in pricing and disregard the additionally incurred socal and environmental costs. Under such circumstances, micro-economically calculated prices are too low and suggest an inefficient allocation of human and natural resources to the economic processes. For the human resources that means: Workers earn insufficient wages, or are underemployed or unemployed, which is macro-economically inefficient, because consumer spending decreases, economic cycles are weakened, and government transfer benefits have to be increased to secure the minimum subsistence level for workers. For the natural resources that means: Unduly low prices are inefficient because they can tempt economic players to waste and exploit resources (see also the article Factors of Production).

For the economic classification of externalities, which is also a precondition for an effective economic governance, a distinction has to be made as a first step between effects that are the »natural« and beneficial result of regulated market economy competition (Category 1), and those that are the result of unregulated competition, and therefore distort competition and cause market failure (Category 2).

The two categories can only clearly be distinguished when the conditions of a future-oriented, socially and ecologically regulated market economy system serve as a reference point, regardless of whether these conditions exist in reality. This is the only way to conclude whether a particular effect arises from sustainably beneficial competition and whether it is conducive to or distortive on competition. This distinction is indispensable when it comes to deriving economic policy measures for social-ecological orientation or development of an economic order from existing conditions.

3. External Effects Conducive to Competition (Category 1)

Constructive market economy competition is by its very nature accompanied by conducive positive and conducive negative external effects. A conducive positive external effect occurs for example when a company raises awareness among potential customers on a particular product through advertising efforts, and direct competitors benefit without any contribution on their part (as free-riders), so that an outdated product is replaced with an advanced one, thus intensifying competition in view of further progress. The most common cause for a conducive negative external effect in competition is the loss of market share, sales and profits through sustainable success of competitors who introduce advanced production technologies and products onto the market. As said above, these negative effects are macro-economically also beneficial, because they improve the market supply and serve progress.

Both effects of this category, positive as well as negative, are desirable and indispensable in terms of constructive market economy competition, because firstly they trigger learning processes and inspire the creativity of suppliers, which is a prerequisite for progress. And secondly because they are included in the national product as positive macroeconomic items from the transactions of successful competitors and free-riders and their customers. However, the required sustainability of these positive items presupposes that the economic policy regime and the calculation of the national product are based on social and environmental criteria, and thus induce qualitative growth.

It is obvious that the perpetrators of the first example above, covering conducive positive external effects, have no right to claim for cost reimbursement against the free-riders. Just as the unsuccessful competitors of the second example, covering conducive negative external effects, are not entitled to claim for liability against the perpetrators or the general public. Principally, victims have no right to demand compensation or economic policy countermeasures in case they are disadvantaged through conducive external effects. Inferior competitors in particular benefit from learning processes giving them the opportunity to improve their competitive position and stay in the race. And even if they are definitively forced out of a market, whether as entrepreneurs or workers, they will always get another chance under social-ecological conditions to contribute to economic life according to their abilities.

It’s the specific quality of conducive external effects that they only affect economic players, meaning individual persons or enterprises, but not natural resources, as opposed to the distortive external effects shown below. Positive as well as negative effects of Category 1 only cause a redistribution of income between the affected players. The necessary socio-ecological regulation and control has to ensure that the redistribution is inducive to domestic as well as international competition without jeopardizing the existence of players. Therefore, there is no need to include these effects in pricing (to internalize them). That is, there is no reason for economic policy to counteract the induced redistributions, because they are the driving force for qualitative growth and progress from which eventually all economic players and the society as a whole will benefit.

However, qualitative growth and progress can only be achieved within economic areas, when international competition is as well autonomously regulated and controlled such that conducive effects from domestic competition can unfold their potential free from destructive foreign influences. Only when such influences are averted through bilaterally agreed, price-neutralizing exchange rates and additionally through tariffs and trade quotas – and international competition is thus based on relative price and absolute qualitative advantages – can cross-border conducive external effects be additionally produced und exploited. For example, when pure domestic competitors are motivated through controlled competition with imported products to incease their productivity and competitiveness to an extent enabling them to intervene in international competition and increase their market share. It should be noted that in controlled international competition, based on relative price advantages, incentives for price-dumping do not arise and systemic, definite crowding-out of competitors is ruled out (see also the article Future-Proof Foreign Trade and Comparative Advantage — upgraded.

4. External Effects Distortive on Competition (Category 2)

ExternalitiesPNG01Figure 1: Distortive external effects on competition are a categorical and inevitable consequence of uncontrolled competition and are the essential cause for social inequality, environmental damage and for falling short of optimal welfare. Or to express it trenchantly: for the endangerment of the natural environment and the human existence. Moreover, they interfere with conducive external effects such that the latter can not unfold any beneficial impact on the economy.

Distortive external effects occur when the relationship between perpetrators and those affected – as determined through the market mechanism of supply and demand and therefore mainly through the price – gets out of balance, because the external benefits or costs originating from economic activities are not at all or only insufficiently considered in pricing and their positive or negative influence on economic resources and the general public remains hidden. As a consequence prices lose their beneficial regulating effect on the allocation of resources to the economic processes, resulting either in undersupply because externalized benefits are not reimbursed to the perpetrators, or in wastefulness and exploitation because externalized costs are not charged to the perpetrators.

It is one of the most important tasks of economic policy to counteract distortive external effects on competition. The appropriate means to this end is the internalization of the effects. Which is affected by reimbursing positive external effects (profits) to the perpetrators by means of state subsidies or legal claims against the beneficiaries, and by charging the perpetrators for negative external effects (costs) through taxation or mandatory charges or simply by prohibiting these effects. By reimbursing external benefits, the perpetrators can reduce prices to contribute to social welfare and produce quantities in accordance with welfare, while the perpetrators of external costs are forced by the charge or prohibition to preserve the resources concerned or to switch to renewable resources. It should be noted that internalizations, apart from some voluntary variants, are always the outcome of deliberate economic policy regulation, and that welfare-oriented internalization presupposes a regulation aimed at the benefit of society and the environment.

Contrary to some assertions, deregulated (unregulated) markets, such as those arising in the course of the current neoliberal globalization, are not able to automatically accomplish internalizations and contribute to welfare.

Social-ecological regulation directed towards society and environment primarily means to create the structural conditions under which distortive external effects take the least possible scale and can be handled with the least possible effort. The priority must be – in terms of constructive market economy competition – to counteract the natural pursuit of concentration of economic power and capital by means of dynamic decentralization or better: subsidiarization of economic structures – as rudimentarily conducted by the German anti-trust authorities (Kartellbehörden). This is the only way to prevent definite crowding-out of enterprises and individuals – that is inevitably accompanied by de-industrialization, unemployment and environmental damage –, and to permanently safeguard diversity and decentralized responsibility. And only under these conditions can competition be described as »the greatest and most ingenious instrument of disempowerment in history«, as expressed by the lawyer Franz Böhm, a protagonist of the Freiburg School of Economics (for more details see the articles Economic Subsidiarity and Economic Competition).

The effective building of subsidiary economic structures under the conditions of the neoliberal globalization as a base for a post-neoliberal economic order is addressed in the article Building Subsidiary Economic Structures.

5. Examples of Distortive External Effects (Category 2)

The most serious threat within the current neoliberal economic system comes from negative distortive external effects, which usually go together with inappropriately high benefits for the perpetrators and inappropriately high costs for those affected, including the general public and the environment. Broadly speaking, a large amount of the benefits (profits) will be privatized and a large amount of the costs socialized. The false pricing and the resulting misallocation of resources distort competition and transform the market mechanism into an instrument of hidden destruction, with the economy drifting further and further away from the state of optimal welfare.

Typical examples of positive distortive external effects on competition are private sector research, development and production projects, such as the exploitation of alternative energies to generate ecological and consequently social returns through reduced emissions of greenhouse gases like carbon dioxide. The distortion of competition is, on the one hand, due to the fact that competitors offer mature, inexpencive products for the use of fossil fuels and thus reduce the rate of returns on investment of alternative products. The internalization, as a task of socio-ecological regulation, is in this case accomplished through government subsidization of alternative productions, enabling producers to generate adequate returns and develop new markets with competitive prices and necessary quantities against the polluting products. Apart from the producers, the purchasers of alternative products contribute to public environmental and social benefits on the consumption side, and should therefore, to complement the internalization, enjoy tax relief for their pioneering role.

On the other hand, distortion of competition can be caused by copycats (imitators) of alternative productions, who take advantage of the groundwork of pioneers, thereby reducing costs, undercutting prices, and finally driving pioneers out of their markets. In this case the necessary internalization of positive distortive external effects must consist of a state-regulated patent protection to prevent short-term imitation or oblige imitators to pay royalties to the pioneers and patent holders.

Examples of the dangerous negative distortive external effects on competition are numerous: work-related accidents, occupational diseases, soil, water and air contamination as external costs of negligent production methods and, not least, unemployment and also environmental pollution resulting from high transport volumes, both being external costs incurred by deregulated markets and centralized productions. In each of the cases mentioned owners of enterprises accrue profits that are associated with high external costs of individuals and the general public. The internalization of costs can be achieved by placing taxation or restrictions upon the causal factors of production or by prohibiting their use.

Generally, the following applies: The closer to the problem source socio-ecological control is exerted, the more effective and more efficient it is, also with regard to the necessary surveillance. It is, for example, more effective and efficient to tax or prohibit harmful substances rather than regulating their disposal. Likewise, it is more effective and efficient to progressively tax company sizes when it comes to prevent monopolization, job losses and environmental pollution caused by centralist economic structures, rather than to enforce complicated anti-trust rules that need to be re-interpreted for each individual case.

6. Scope of Distortive External Effects (Category 2)

Crucial to the understanding of the risk potential of distortive external effects is the fact that all factors of production can be affected: namely labor, natural resources and production capital. Distortions, especially those occurring in neoliberal cut-throat competition, are not only caused by prices set too low for natural resources, production capital and final products, but also by wages that are deliberately calculated too low (wage dumping). The latter is given when industries increase wages more slowly than productivity gains would demand. With both price and wage dumping companies aim to improve their competitive position first and foremost in international competition. Dumping is successful because international competition is deregulated and thus based on absolute prices in US dollars or euros. That is, different productivity and price levels between countries and their enterprises can not be neutralized or compensated because foreign exchange rates, although they still exist, are not applied, and customs duties are also not applied. The distortion of competition through wage dumping has, at the same time, a devastating domestic impact. On the one hand, as mentioned above, because distortions decrease the purchasing power of workers and weaken economic cycles, and on the other hand, because they increase the returns of capital owners involved, leading to extreme inequality of income and poverty at the lower end of income.

Since international competition can not be uniformly governed – given the inhomogeneity of the world – the control of distortive external effects on competition also depends on autonomous bilateral trade agreements with respect to exchange rates, tariffs and quantitative restrictions. Such agreements are vital to allow market players to compete on relative price and absolute quality advantages, and to utilize or prevent external profits or costs respectively in both directions of (bilateral) foreign trade. This requirement currently gains existential significance because national and supranational economic influence is in constant decline under the conditions of the neoliberal globalization, and external costs provoked through trading on unregulated global and intra-European markets are taking on an ever greater threatening dimension.

7. Methods of Internalization (Category 2)

The purpose of economic policy-driven internalizations is to continually bring economic processes in line with the welfare optimum by reversing their »natural« tendency towards concentration of power and capital and privatization of profits.

The welfare optimum is defined as a condition in which

  1. all citizens willing to work participate in economic life in self-determination,
  2. all workers have a performance-related share in the economic outturn as a living wage by regularly adjusting wages and working hours to productivity gains,
  3. the distribution of income is accomplished in a performance-related and well-balanced manner through progressive taxation, so that all income groups contribute to the diversity and functionality of economic cycles, and
  4. the non-renewable resources are recycled in technical cycles or replaced by renewable ones, and renewable resources not being used beyond their natural regeneration capacity and returned to their biological cycles after use.

In short: Optimum welfare is attained in a state of lasting full employment and sustainable environmental protection. For a detailed description of the conditions for welfare, I recommend the article Sustainable Social Welfare.

To achieve sustainable welfare, the politically intended mechanism for internalizations must be an integral part of the economic order. A distinction must be made here between ongoing systemic internalizations and selective or temporary ones. The latter are conducted on a case-by-case basis or for limited periods in order to give economic players the opportunity to gradually correct undesirable developments in a phase of transition to a sustainable economic system. There are, in addition, a number of other types of internalization based on voluntary participation and self-interest.

In general, the following applies to all distortive external effects: The more directly internalizations tackle the roots of effects, the more effective and efficient they are. If internalizations, however, merely address the symptoms of external effects, they will entail new (secondary) effects.

Systemic, Permanent Internalizations

Progressive income tax for the purpose of balancing the distribution of income and thus to keep economic cycles going as all citizens enjoy equally high marginal benefit from their consumption expenditure, and external costs resulting from low tax revenues are avoided.

»Citizens« insurance against major life risks such as illness, long-term care, old age, and unemployment, based on mandatory premiums of an equal percentage of income for all citizens in order to keep social costs and subsequent tax-financed transfer payments as low as possible.

Progressive taxation of non-renewable natural resources (including land) to restrict their use and to promote their reuse (recycling), or the substitution thereof by renewable resources, including energy sources and energies, and to avoid incalculable external costs caused by wastage and exploitation.

Progressive taxation of renewable natural resources in order not to extend their use beyond their natural regeneration capacity, and to avoid incalculable external costs caused by their partial or definite destruction.

Progressive taxation of company sizes to counteract the »natural« tendency of economic structures towards centralization and capital concentration, and to avoid external costs caused by area-wide de-industrialization, unemployment and high transport volumes.

Bilateral fixed exchange rates, tariffs and trade quotas to enable welfare-oriented foreign trade and competition based on comparative relative price and absolute quality advantages, and to avoid external costs caused by international predatory competition and its consequences. In other words: to replace the systemic neoliberal compulsion to unilaterally act against malicious economic attacks and the associated mutual accusations of protectionism in the World Trade Organization (WTO) with a sensible national protection in foreign trade that is mutually conducive to prosperity (see also the articles World Trade Organization (WTO) and Protection and Protectionism).

Approval/taxation of capital transfers (monetary and physical capital) in order to avoid external costs caused by capital flight and to enforce the location-bound social and environmental obligation of capital.

Ban on purely speculative financial transfers, such as short selling of shares, in order to prevent external costs caused by manipulated share prices and their consequences, including the associated redistribution of income and wealth.

Selective and Temporary Internalizations

Simple bans are appropriate, for example, to prevent the use of toxic substances. However, bans are only effective when violations are subject to a penalty that makes the use of banned substances absolutely unattractive. The penalty for a certain amount of a toxic substance can be considered as its price that has the effect of an internalization.

Another example are speed limits in road traffic. Again, the violation of a limit must be punished with a degree of penalty that effectively disciplines road users, and that can, at the same time, be perceived as a reasonable price for the consequences of a violation, and hence internalizes the actual costs of a violation or the calculated average amount of costs of a particular type of violation.

Using the example of speed limits, the differences between causal and symptomatic internalization can be shown: In case a speed limit is decided to reduce the noise produced by vehicles, the measure is aimed directly against the source of the noise (the cause), and is therefore very effective and very efficient. In case the traffic noise is reduced by a noise barrier, the measure is not aimed at the cause, but merely reduces the spread and the effects of the noise. It is characteristic of such a symptomatic measure that it entails secondary externalities:

  1. Its implementation and funding has to be enforced against competing public projects.
  2. Its funding is controversial, because landowners may have to be financially compensated,
  3. beneficiary citizens may not be willing to contribute to the funding, and
  4. other noise-plagued neighbors may take legal action aiming to be included in the project.

Emission allowances (emission rights certificates) are a suitable preliminary stage for banning toxic substances in case it’s too early to impose bans as suitable substitutes or technologies are not yet available. Emission allowances are defined by national legislators for an initial annual maximum amount of a pollutant – such as carbon dioxide per megawatt hour for power plants –, and proportionately sold to the emitters at a fixed price, or assigned by supranational legislators for an initial maximum amount – such as carbon dioxide per inhabitant of a country. Emission allowances are ecologically sensible only if

  1. the maximum permitted quantities are reduced annually depending on technological progress until an environmentally compatible amount of emissions or a complete ban is achieved within the foreseeable period, and if
  2. assigned allowances can be traded between emitters at prices determined by the interplay between supply and demand (market mechanism).

In addition, emissions that are dispersed by emitters into the environment without a valid allowance, must be subject to a quantity-dependent deterrent penalty. The issuance of emission allowances has the advantage over taxation that the relief of the burden on the environment can be quantified fairly accurately for the transitional period, and the emitters can also roughly predetermine their conversion costs.

The trading of emission allowances has the advantage that the relief on the environment is effected through macroeconomically lowest costs, because the sales potential of emission allowances creates incentives for emitters to undercut their proportinal maximum amount by applying the most effective and efficient technologies and prevention strategies. In other words: Each year, when the assigned proportinal maximum amounts are reduced, each emitter can freely decide whether it is more cost-efficient to invest in new technologies or to purchase additional allowances. Emitters must thereby consider the price trend of emission allowances: The less is invested in new technologies in total, the higher the prices rise. That is, the market mechanism ensures, together with the threat of penalties, for a macroeconomic optimization of the process.

Insurance premiums of private sector insurance companies are appropriate to quantify risks of side effects of new and dangerous technologies (to monetize them), or to answer the question, whether these risks are insurable at all. This is an elegant method for legislators to ban technologies with risks that are commercially classified as uninsurable. For example, parts of the green gene technology and in particular the nuclear technology are considered uninsurable. On this basis it means that as long as no ban on these technologies is enforced, the profits continue to flow to the producers, while the general public will be saddled with the risk of incalculably high costs.

Other Methods of Internalization

Apart from internalizations enforced by economic policy there are also those that are carried out by private sector players voluntarily and in their own interest. When these internalizations occur on a large scale, they are, on the one hand, a display of advanced enlightenment in society, on the other hand, also an indication of insufficient effectiveness of systemic internalizations. Voluntary internalizations are basically unsuitable to replace systemic ones – the latter being intended by their very nature to contribute to social welfare –, at best they can complement systemic ones and in particular curb external effects of locally limited projects where contracting parties maintain direct contact.

The voluntary internalizations include:

  1. social norms to motivate citizens to behave in a socially and environmentally responsible manner,
  2. volunteer activities and charitable foundations among citizens for the compensation of externalized social and environmental costs that are not covered by systemic internalizations,
  3. entrepreneurial vision that motivates entrepreneurs to refund externalized social and environmental costs incurred by individuals or the general public, and
  4. contractual arrangements, such as guarantees, financial compensations or technology transfers, to be agreed between those contracting parties that face each other with equal rights of disposal over the affected resources and therefore are able to mutually offset externalized costs.

Click here for the German-language version: Wirtschaftliche Externalitäten

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