Question

How does externalities affect the economy?

Answer 1

Externalities are defined as events or effects that can affect an activity with which they are not related to.

Positive externalities cause a good effect on its object, while negative ones cause a bad effect.

Though sometimes it might be a bit blurry for us to state when something is an externality and when it's actually related to the core activity, some extreme examples might clarify our understanding.

Let's just imagine an archipelago in Eastern Indonesia, where people farm tobacco. We know that many volcanoes around Indonesia are active and might erupt at any time. Now, suppose that a volcano in those islands erupt and end up damaging, burning, withering and so on the local farms. We can infer that volcano eruption as a negative externality in the activity of tobacco farming.

Exercise: imagine, now, whole industries being taken away by hurricanes, tornadoes, tsunamis and other natural disasters.

Another negative externality, now a real one. Guinea is an African country rich in iron. Mining responds to more than half of all exports revenue for Guinean economy. Recently, the ebola epidemy which spread all over West Africa reached Guinea as well. It struck a blow on local economy, as soon workers were becoming ill or even dying; there were quarantines, which reduced the working time of the whole economy in order to prevent more spreading of the disease.

You can imagine that an economy with more restrained opening and closing hours does sell less, generates less wealth, increases unemployment, etc.

The loss is greater to the society than it is to the individuals, even though they do harm individuals alone.

Now, a positive externality: immunization via vaccination. One individual gets immunized to some diseases, but has also the positive effect to society that he will not be able to pass on transmissive diseases to other individuals. We can infer that this individual's society is benefited by one's immunization; thus, one's immunization has a positive impact for a great group of people besides himself.

In Economics terms, we can state that a positive externality happens when society/a big group benefits more than a single individual from that single individual's actions.