Big picture: An externality is a cost or benefit that affects a third party who did not choose to incur that cost or benefit. Environmental problems are often caused by negative externalities.
- Negative externality
- A cost imposed on third parties not involved in a transaction (e.g., factory pollution affecting local residents).
- Positive externality
- A benefit received by third parties not involved in a transaction (e.g., a beekeeper's bees pollinating nearby farms).
- Social cost
- Private cost + external cost. The true cost to society of producing a good or service.
Examples of negative environmental externalities
- Air pollution from factories causing respiratory disease
- Agricultural runoff causing eutrophication in waterways
- Carbon emissions contributing to climate change
- Noise pollution from airports reducing property values
IB exam tip: Always explain WHO bears the external cost and HOW — this shows you understand the concept beyond the definition.
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Key concept: Market failure occurs when the free market fails to allocate resources efficiently, leading to overproduction of harmful goods or underproduction of beneficial ones.
- Market failure
- When markets do not account for all costs (especially environmental costs), leading to inefficient outcomes.
- Public good
- A resource that is non-excludable (cannot prevent anyone from using it) and non-rivalrous (one person's use does not reduce availability for others).
- Free rider problem
- When individuals benefit from a public good without contributing to its provision or maintenance.
- Tragedy of the commons
- When shared resources are overexploited because individuals act in self-interest rather than for the collective good.
Examples of environmental public goods
- Clean air
- Stable climate
- Biodiversity
- Ocean fish stocks (partially rivalrous)
- Ozone layer
IB exam tip: Link the tragedy of the commons to specific environmental issues like overfishing, deforestation, or climate change.
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Methods to internalise externalities
- Taxes on pollution (e.g., carbon tax) — makes polluters pay the social cost
- Subsidies for clean alternatives (e.g., renewable energy subsidies)
- Cap-and-trade systems — set total emission limits and allow trading
- Regulation — direct limits on emissions or resource use
- Property rights — assigning ownership of commons to prevent overuse
Key concept: Internalising externalities means making the polluter pay the full social cost of their actions, so the market price reflects the true cost to society.
Supply and demand explanation (HL): In a negative externality, the marginal social cost (MSC) curve lies above the marginal private cost (MPC) curve because external costs are not included in the market price. The free market equilibrium therefore overproduces relative to the socially optimal level, creating a welfare loss.
- Pigouvian tax
- A tax equal to the external cost of production, designed to internalise negative externalities and shift output toward the socially optimal level.
- Social cost
- Private cost plus external cost. It represents the true cost to society of producing a good or service.
IB exam tip: In analyse or evaluate questions, explain that markets reflect private costs only. A Pigouvian tax shifts behaviour by forcing firms to face the social cost, reducing overproduction.