Definition of externalities

Positive externalities can be defined as cost savings to a company that result from the concentration of firms and industries at a given location. The net benefit to being in a location together with other firms, is argued to increase with the number of firms and industries at the location, creating external economies.

(Positive externalities can also result from the external provision of a benefit, such as a road, to a company that previously had poor infrastructure connnections. It is also possible to have negative externalities, such as pollution from economic activity, see externality.)

A localised industry of competing firms creates an external economy of scale, or localisation externality. The large number of competing firms at a location attracts workers and suppliers, and can increase a firm’s returns, according to the economist and newspaper columnist Paul Krugman.

Labour market pooling benefits both workers and companies since a large labour pool helps the individual firm cope with the uncertainty related to the firm business cycle. Urbanisation externality arises from the diversity of industries in a city or region. Thriving industries at a location draws a more diverse labour pool and brings about better infrastructure and all other benefits associated with the formation of cities. For example, a competitive machinery maintenance industry, which provides specialist support to the food processing industry at a location, may also attract another a new industry – a paper processing industry- which seeks to benefit the form of urbanisation externality. This is an external economy of scope brought about by diversity of industries in urban concentration typically.

A pecuniary externality is said to exist if the profits of a firm depend not only on its own activity but also on the activities of other firms in upstream and lateral industries at the location. This is a complex external economy due to economic transactions taking place between such firms in upstream and lateral sectors. For example, the nature of insurance and reinsurance processes involves a chain of insurance firms and private equity holders in London's financial centre to spread the risk acquired of a profitable venture, and therefore bring net pecuniary benefits to all involved. A positive pecuniary externality arises in such clusters when the economic benefits outweigh the cost of clustering, such as the increased congestion and transportation costs.[1]