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Externalities or external costs

The issue of pricing can be broken down into a number of components:

In this unit, we are looking at externalities

Externalities or 'external costs' are costs of production and consumption which normally lie outside the pricing system or market mechanisms. These are often called 'global commons' – common lands, rivers, forests, the oceans, the atmosphere, to which there is free access , which has led, and continues to lead, to their over-exploitation (Hardin, 1968).

For example, imagine a village surrounded by common land. If a farmer puts far more sheep on a common field than anyone else, then they will get more profit overall than anyone else, even if this is more than can be sustained and destroys the field in the process. This is known as 'the tragedy of the commons.'

The video below gives a useful overview of environmental economics, including a discussion of 'the tragedy of the commons':

environmental crash course economics

View environmental crash course economics video transcript

The external costs of production or consumption of goods or services have effects, which are often imposed on others (both inorganic and organic – human, animal or plant), but cannot be traced or charged back to the originator. There is often separation between the affected individual and the source of the effects and it can become very difficult to make the originator pay for any of the costs of harmful effects (e.g. pollution, removal of a habitat, waste, global warming) that they have imposed on others.

How to manage global commons? This needs an international agreement, in the form of controls that regulate access to vulnerable resources, or mechanisms such as taxes or levies that raise finance for investment and environmental protection.

Individual nations can use policies to try to control external costs, but in the end, international agreements must be reached through a regulatory framework in the form of a convention or protocol. Countries must reach agreements amongst themselves and also have measures within their country to enforce them.