Externality Of Production

Published Mar 3, 2023

Definition of Externality of Production

The term externality of production refers to a spillover effect that takes place when the production of goods or services creates unintended impacts on third parties not involved in the production process. In other words, it describes the cost or benefit imposed on another party due to the production activities of a firm. This can either be positive or negative, depending on whether the impact is beneficial or detrimental to the third party.

Example

A common example of a negative externality of production is pollution. Let’s say there is a factory that produces steel. The process of making steel results in the emission of harmful chemicals into the air, soil, or water, which can affect the health and quality of life of people in the surrounding areas. This impact is not reflected in the price of steel, nor is it borne by the company that produces it. Thus, the cost is externalized or passed on to the residents, who have to pay for medical care, cleanups, or lower property values.

On the other hand, an example of a positive externality of production could be a company that invests in employee training programs. By doing so, the company not only increases the skills and productivity of its own workforce but also contributes to the overall growth and development of the labor force. This, in turn, benefits other companies, as they can hire more skilled workers and individuals, as well as the individuals themselves, as they have a higher chance of finding better-paying jobs.

Why Externality of Production Matters

The concept of externalities of production is crucial for economists, policymakers, and businesses alike, as it provides insight into the unaccounted costs and benefits created by production activities. If the price of goods or services does not reflect the total social costs and benefits, it may lead to underproduction or overproduction, depending on whether the externality is negative or positive. Therefore, understanding and addressing externalities of production is essential for achieving efficient and equitable outcomes in the market.