Externality

Definition of "Externality"

Written by

Kyna Smith

William Raveis Real Estate - Siesta Key

If you have been wondering what can cause a market failure, the most common answer is externalities. An externality is an indirect cost or benefit to a neutral third party that comes from another party's behavior in economics. 

Externalities are unpriced items engaged in either consumer or producer market transactions. One example is air pollution caused by motor vehicles. The producers and the consumers of cars won't pay the cost of air and noise pollution to the rest of society.

Externalities affect market transactions.

Most economic activities generate spill-over benefits and expenses. Generally, externalities are overflowing effects that spread into another economic area. They emerge from production or consumption instances for which no adequate repayment is received. Quintessentially, you'll find externalities arising from outside the original market transaction or price. They affect people indirectly involved in the production or consumption. 

What do private and social costs and benefits mean?

Private costs (or internal costs) are the expenses a manufacturer or consumer deals with who are otherwise directly involved in a transaction. Secondly, private benefits are the gains the producer, such as their income, and consumers (for instance, utility satisfaction in the case of transportation means) enjoy directly involved in a business dealing. 

We must also know what social cost means. Social costs are the amount resulting from private and external costs. Once externalities occur, they lead to a difference between private and social costs of production as well as the private and social benefits of consumption. At the same time, social benefits equal private and external advantages or profit.

What do negative vs. positive externalities define?

We must introduce the terms negative and positive externalities. Negative externalities generate spill-over costs. It signifies the case when social costs surpass the private costs. If producers don't consider and take action against negative externalities, they can result in over-production and market failure. 

Our previous example, pollution, is a feared negative externality. Let's suppose a company wishes to reduce costs and increase its profitability by implementing environment-damaging operations. The company can therefore achieve returns higher than its expenses. These can be a threat for real estate developers, too.

On the other hand, positive externalities create overflowing advantages. Social benefits eclipse private benefits. As an example of positive externalities, we can mention research and development projects that boost a company's private profits and expand a society's general knowledge. Education, in general, is a positive externality. Investing in education contributes to forming a more competent and more knowledgeable workforce. Companies can cut costs because employees require less training and development. 

How do externalities contribute to a failing market? Externalities apply when the price mechanism doesn't consider social expenses and benefits of consumption and the production of goods and services.

How do externalities influence real estate?

Externalities are a common phenomenon in real estate markets. 

Positive externalities in real estate

Positive externality implies investments in and care of one neighbor's properties impact the attractiveness and general amenities of other neighbors' streets and neighborhoods. Thus, they influence the value of their property. 

Because neighbors do not reward one other for painting their houses or mowing their lawns, the impacts of other residents' investments on the value and services gained from an owner's property are an externality. As a result, the investment in a property (the economic transaction) indirectly affects a person not directly participating in the transaction (the neighbor), who cannot demand payment or be compensated.

Such externalities lead to remarkable housing and a decrease in social problems, for instance, drug abuse and crime. The process and outcome of gentrification can be considered an externality. In addition, it can lead to better environmental and public health standards in a neighborhood. Thirdly, building new homes prevents the US shortage of housing supply. Also, retail development can boost your property’s value. 

Negative externalities in the housing market

Likewise, detrimental factors can indirectly decrease your home's worth. Pollution, chemicals, burning coal can result in the local fauna and sauna sustaining heavy damages. Anglers can't catch fish. Them losing income will define a negative externality. Moreover, contamination can tarnish a neighborhood's reputation and diminish local real estate prices. Driving cars results in air pollution and congestion. Additionally, we can consider building a new road a negative externality because it affects the landscape and the environment.