Externalities can be defied as a cost or a benefit that arises from an economic transaction and that falls on people who don’t participate in that transaction. In other words, externalities are outcomes of a transaction that fall on third parties who are not parties to the transaction. Is an example passive smoking is an externality which causes as a result of smoking and it affects non smokers who are not a party to the transaction of smoking.

There are 02 types externalities:

Positive Externalities-

This is where the social benifit of the transaction is higher than the private cost of the transaction. In other words, as a result of a transaction, not only the parties of the transaction third parties (society) too get benefited. As an example, primary and secondary education not only benefit the person who learns but also it benifits the society by creating an educated person who can serve the society in return avoiding crimes. As examples of positive externalities green marketing, green production, water supply projects as community services and all other social service activities can be identified.

Negative Externalities-

This is where the social cost of the transaction is higher than private cost of the transaction. This is where a transaction results in adverse outcomes to the society who are not the party to the transaction. As an example, Passive smoking result in cost to the society where a non smoker gets passive smoked even though s/he purposely did not smoke. Other examples of negative externalities are green houe gas emission, garbage dumping, air pollution, land pollution and noise pollution by production plants.

Correction of Negative Externalities

  • Taxation- This is where the government imposes taxes on the person who creates negative externalities. The tax will equal the private cost to the social cost which will delete the external effects of the transaction. As an example, government imposes excise duty on alcoholic products to make sure the private cost of the transaction is made high which will lower/delete the social cost resulting in no externalities situation.
  • Imposing laws and regulations-  This is where the government imposes law to completely prohibit consumers engaging transactions with negative externalities. As an example, few years ago many countries banned usage of equipment releasing CFC gas which reduced the emission of green house gases  resulting in no externality situation.
  • Tradable allowances- This is where the government imposes a limit up to which a certain transaction can cause negative externalities. As example, government grants permission for a firm to engage in activities which can cause air pollution but it is up to 15% of total pollution level. This will limit the pollution level of the economy.

As opposed to correcting negative externalities positive externalities are encouraged by government grants/subsidies, tax reliefs for positive externalities creators and provision from government expenses such as defense expenses and health expenses.

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