Public Policies & Externalities in Microeconomics

Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

Expert Contributor
Joseph Shinn

Joe has a PhD in Economics from Temple University and has been teaching college-level courses for 10 years.

Economic activity can have both positive and negative side-effects. This lesson will discuss externalities, and how public policy is used to boost the positive side-effects and lower the negative side-effects.

Externalities in Microeconomics

An externality is an unintended consequence of an economic activity. It is experienced by other parties not related to the transaction. The most well-known externality is pollution. During the production of a good, pollution is released into the environment. This is a negative externality because it affects the health and welfare of the surrounding community.

Externalities can also be positive, such public vaccination clinics, public sanitation, and education. These benefit others that do not participate in the activity. We'll discuss some examples of these in greater detail, specifically in regard to public policy. First, let's take a look at some of the consequences of externalities.

Consequences of Externalities

When we talk about externalities, much of the focus is on the negative consequence of an economic activity. A negative externality happens when a business or individual doesn't pay the full price for their actions. This means that the brunt of the cost is passed on to society. All things being equal (without external influence), a deadweight welfare loss can occur. This is where the benefit of an activity doesn't equal the cost. The producer enjoys lower costs, but society pays the price.

Take a look at the following supply curve. The orange line shows the supply and marginal cost for society. The blue line is that of the company facing the negative externality. Optimal production is at Q1, but the negative externality pushes society's cost higher. The deadweight loss is in pink.

Deadweight loss externality

When we look at positive externalities, however, the consequences are generally positive. Education, public sanitation, and vaccination clinics are examples of this. Instead of thinking of a cost to a third-party (pollution causing sickness in the surrounding population), we think of the benefit to those who aren't part of the economic activity. For example, let's consider public sanitation, it isn't only the street sweepers who benefit. The public benefits from a cleaner environment.

Public Policy

You'd think that a completely free market would self-regulate. That, all things being equal, these things would take care of themselves. The Coase Theorem is an economic theory that externalities would be taken care of if property rights are allocated to all, and the market is set up for free trade. In other words, you give property rights to clean air so you can sue the factory if their smoke gives you cancer. Unfortunately, it does not play out quite like this. In this case, we need public policy to offset negative externalities and foster positive externalities.

Positive Externalities

One way to create positive externalities is to increase the supply. This can be done through grants or subsidies. Examples of these include subsidies paid to farmers. Tax revenues can also be used to develop and maintain roads, bridges, or airports. The government can increase supply and demand. One way to increase demand is to reduce prices to encourage purchase from customers. Subsidizing tuition can be a tool to encourage college attendance. This, in turn, benefits future generations.

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Additional Activities

Additional Practice:

For each of the following situations, determine the following: (1) Is an externality being described, (2) is the externality positive or negative, (3) what is the externality, and (4) who is receiving the externality (if anyone)?

  1. A neighbor in your neighborhood spends a lot of money on his yard to make it look nice.
  2. When commercial airlines fly passengers across the country, pollution is generated from the fuel that the airplane is burning.
  3. Instead of driving your car to work every day, you decide to ride your bike.
  4. Your neighbor is playing loud music that most people find undesirable.
  5. People smoke in a public setting, resulting in others inhaling the smoke (second-hand smoke).
  6. You get a flu shot that makes it less likely that you will get the flu.


  1. A positive externality is generated because property values will rise. The recipients of the externality will be the neighbors.
  2. A negative externality is generated, and society as a whole experience the externality.
  3. This action creates a positive externality because less pollution is being created.
  4. A negative externality is generated because this is a type of noise pollution.
  5. A negative externality is generated with the recipient being the non-smokers.
  6. Flu shots create positive externalities for those who do not get the shot because if those who get the shot are less likely to get sick, those who do not get the shot will be less likely to get the virus.

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