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Last Updated: 2006

Externalities are uncompensated third-party effects resulting from the production and/or consumption of goods and services. In other words, an externality results from the gap between the private cost or benefit of a good and the social cost or benefit of the good. A spillover is an externality that spills over into areas beyond the authority of the government where the externality is produced. For example, pollution is an externality, because the producers of pollution do not bear the full social and environmental costs of that pollution. The acid rain that falls in the eastern states is a spillover of the pollution produced by coal-burning electric generators in American midwestern states.

Externalities are a form of market failure and, as such, justify governmental intervention to correct. When externalities become spillovers, governments with broader jurisdiction (e.g., state or nation) may be necessary to correct or alleviate the externality/ spillover, because such a government may have jurisdiction over where the externality is produced and where the effects of the externality are felt. Also, these governments often have greater expertise for responding to the externality. Consequently, the existence of, or potential for, externalities and spillovers is often used to justify national standards and programs.

Externalities/spillovers may result from interjurisdictional competition. Without state or national standards, local governments may reduce their environmental standards, labor protections, welfare programs, and taxes as a means to attract businesses to move to their locality. Other governments competing for those same businesses may feel pressured to respond in kind in order to attract the businesses. This interjurisdictional competition may result in a “race to the bottom” as each government seeks a competitive edge by reducing its standards below the other. There is little evidence supporting the interjurisdictional competition or race-to-the-bottom theses, because most businesses’ location decisions are based on not just cost but also quality of life issues.

Externalities/spillovers reveal important tradeoffs that occur in a federal system. According to Gordon Tullock (1994), the smaller the government, the more likely the government will reflect the interests of the citizens, the more likely the small government will produce spillovers that affect others, and the more likely outsiders will produce externalities that spill over and affect those within the small government. This tradeoff establishes a justification for a federal form of government, under which local governments can be responsive to citizens and governments with broader jurisdiction can correct or alleviate externalities and spillovers.

SEE ALSO: Environmental PolicyWelfare Policy


Paul E. Peterson, The Price of Federalism (Washington, DC: Brookings Institution, 1995); Susan Rose-Ackerman, “Does Federalism Matter? Political Choice in a Federal Republic,” Journal of Political Economy 89 (1981): 152–65; and Gordon Tullock, The New Federalist (Vancouver: Fraser Institute, 1994).