Define Externalities. Present a brief about types of externalities. Explain how internalisation of negative externalities could be a solution to externalities through the instruments of taxation and property rights


Externalities are unintended side effects or spillover effects of economic activities that impact individuals or entities not directly involved in the activity.

These effects can be positive or negative and are not considered by those undertaking the activity, leading to a divergence between private and social costs or benefits.

Types of Externalities:

  1. Positive Externalities:
  • Definition: Positive externalities occur when the external effects of an economic activity benefit others who are not directly involved in the activity.
  • Example: Education – an educated individual not only benefits themselves but also contributes positively to society.
  1. Negative Externalities:
  • Definition: Negative externalities occur when the external effects of an economic activity impose costs on others who are not directly involved in the activity.
  • Example: Air pollution from industrial activities impacting the health of nearby residents.
  1. Production Externalities:
  • Definition: Production externalities arise when the production process of one firm affects the production capabilities or costs of another firm.
  • Example: Noise or pollution from a factory affecting neighboring businesses.
  1. Consumption Externalities:
  • Definition: Consumption externalities occur when the consumption of a good or service by one party affects the well-being or utility of others.
  • Example: Smoking in public places affecting the health of non-smokers.
  1. Network Externalities:
  • Definition: Network externalities occur when the value of a product or service to an individual depends on the number of other users.
  • Example: The value of a social networking platform increases as more people join.

Internalization of Negative Externalities:

To address negative externalities, internalization involves incorporating the external costs into the decision-making process of the individuals or firms generating those costs. Two common instruments for internalizing negative externalities are taxation and property rights:

  1. Taxation:
  • Idea: By imposing taxes on activities that generate negative externalities, the government can increase the private cost of those activities, aligning them more closely with their social costs.
  • Example: Carbon taxes imposed on industries emitting pollutants, encouraging firms to reduce emissions and internalize the environmental costs.
  1. Property Rights:
  • Idea: Assigning property rights over resources affected by negative externalities allows the affected parties to negotiate and reach agreements, internalizing the external costs.
  • Example: Tradable emissions permits – firms can buy and sell permits to emit a certain amount of pollutants, providing an incentive for reducing emissions efficiently.


Consider a factory emitting pollutants into a river, causing harm to downstream farmers. Without intervention, the factory might not consider the harm caused to farmers when deciding the level of pollution. To internalize the negative externality:

  1. Taxation: The government imposes a tax on the factory based on its level of pollution. This tax increases the factory’s cost of pollution, encouraging it to reduce emissions.
  2. Property Rights: The downstream farmers are granted property rights to the quality of water in the river. The factory must negotiate with the farmers to obtain the right to pollute. This incentivizes the factory to minimize its pollution to reach a mutually beneficial agreement.

Internalizing negative externalities through taxation or property rights helps achieve a more socially efficient outcome by aligning private decision-making with the broader impacts on society. It promotes a more sustainable and equitable allocation of resources.

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