Externality
In economics, an externality is a cost or benefit from an economic transaction that parties "external" to the transaction receive. Externalities can be either positive, when an external benefit is generated, or negative, when an external cost is imposed upon others.
An externality occurs when a decision causes costs or benefits to third parties (stakeholders), often, though not necessarily, from the use of a public good (for example, production which causes pollution may impose costs on others, making use of the public good air). In other words, the participants do not bear all of the costs or reap all of the gains from the transaction. As a result, in a competitive market too much or too little of the good may be produced and consumed from the point of view of society, depending on incentives at the margin and strategic behavior. If third parties benefit substantially, such as in areas of education or safety, then the good will be under-provided (or under-consumed); if costs to "the public" exceed costs to the individual(s) making the choice in areas such as pollution then the good will be over-provided, from society's point of view. The "point of view" is specified as the greatest collective economic utility for society.
This should be contrasted with purely private economic agreements that do not affect third parties, where the assumption may be made that, if each party is acting in his or her own interests (as defined by utility) and there are no other major market failures, the agreement or exchange improves overall utility for society. Put more simply, if an economic transfer between two parties enhances the utility of both without negatively affecting the utility of any third party, the well being (collective utility) of society is improved; if the utility of others is harmed, it is no longer unambiguously clear that society's collective utility has increased, and may have decreased.
Implications
To most economists, the problem of an externality usually concerns the results of market activity. Economists see voluntary exchange as mutually beneficial to both parties in an exchange. On the other hand, either the consumption of a product such as perfume or other luxuries or its production may have external effects — as in the diagram. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost. The left-hand-side of the diagram shows consumption externalities, such as those of perfume, while the right-hand-side shows production externalities, such as those produced by a perfume factory.
From the perspective of a social planner or welfare economist, this will result in an outcome that is not socially optimal. From the perspective of anybody affected by the externality, it is either a negative factor in their lives, as with pollution by the factory (or the wearer), or a boon, such as the pleasant smell of those wearing the perfume (in the opinion of some). In the first case, the person who is affected by the negative externality in the case of air pollution will see it as lowered utility: either subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality even be seen as trespassing on their lungs, violating their property rights. Thus, an external cost may often pose an ethical or political problem. Alternatively, it might be seen as a case of poorly-defined property rights, as with, for example, pollution of bodies of water that may belong to no-one (either figuratively, in the case of publicly-owned, or literally, in some countries and/or legal traditions).
An external benefit, on the other hand, may increase the utility of third parties at no cost to them. In effect, it can be called a "free lunch" for them. Since the collective utility of society is improved but the direct participants have no way of monetizing the benefit, there is the likelihood that less of the good will be produced or consumed than would be optimal for society as a whole. Typical examples of goods with positive externalities include education (which is believed to increase overall productivity and therefore well-being) and health care (which may reduce the health risks and costs for third parties). Positive externalities are frequently associated with the free rider problem. For example, individuals who are vaccinated reduce the risk of contracting the relevant disease for all others around them, and at high levels of vaccination, society may receive large health and welfare benefits; but any one individual may receive most of the benefits at no expense by "free riding" on the costs borne by others.
There are a number of potential means of improving overall social utility when externalities are involved. The most efficient means of correcting for externalities is to "internalize" the costs and benefits, for example, by requiring a polluter to repair any damage caused. In many cases, however, internalizing costs or benefits is not feasible or the costs uncertain.
The value of the effects of the externality may be difficult to calculate in a technocratic way by economists or social planners, since they reflect the ethical views and preferences of the entire population: it may not be clear whose preferences are most important; interests may conflict; the "value" of the externalities may be difficult to determine; and all parties involved may attempt to influence the policy responses to their own benefit (particularly if "others" can be made to pay for the proposed solutions). Because it may not be feasible to monetize the costs and benefits, some method is (arguably) needed to either impose solutions or aggregate the choices of society. This may be through some form of representative democracy or other means. Political economy is, in broad terms, the study of the means and results of aggregating those choices and benefits that are not limited to purely private transactions.
Sometimes, laissez-faire economists such as Friedrich Hayek and Milton Friedman refer to externalities as "neighborhood effects" or "spillovers". Externalities may, however, be neither small nor localized.
Going outside the broadly-defined liberal political tradition, Marxists see externalities of all sorts, including pecuniary ones, as ubiquitous, being the rule rather than the exception. Production is socialized or totally interdependent. On the other hand, under capitalism, property rights, the appropriation of income, and the making of economic decisions are largely individualized. In order to solve this contradiction between socialized production and individual decision-making, Marxists often call for democratic economic planning, as a key part of socialism.(cf. Frederick Engels, "Socialism: Utopian and Scientific")
Types of externalities
Examples of negative externalities (external cost or external diseconomy) include:
- Pollution by a firm in the course of its production which causes nuisance or harm to others.
- The harvesting by one fishing company in the ocean depletes the stock of available fish for the other companies and overfishing may result. This is an example of a common property resource, sometimes referred to as the Tragedy of the commons.
- Individuals collectively choose to use a public transportation resource (such as roads), imposing congestion costs on all other users.
- A business, like an airline company or software company, may purposely underfund one part of their business, such as their pension funds, in order to push the costs onto someone else, creating an externality. Here, the "cost" is that of providing minimum social welfare or retirement income; economists may more frequently attribute this problem to the category of moral hazards.
- A property tycoon buying up a large number of houses in a town, causing prices to rise and therefore making other people who want to buy the houses worse off, perhaps by excluding them from the housing market. These effects are sometimes called "pecuniary externalities"; many economists do not accept the concept of pecuniary externalities, attributing such problems to anti-competitive behavior, monopoly power, or other definitions of market failures.
Many of the most important negative externalities in the economy are concerned with pollution and the environment. See the article on environmental economics for more discussion of externalities and how they may be addressed in the context of environmental issues.
Examples of positive externalities (beneficial externality, external benefit, external economy, or Merit goods) include:
- A beekeeper keeps the bees for their honey. A side effect or externality associated with his activity is the pollination of surrounding crops by the bees. The value generated by the pollination may be more important than the value of the harvested honey.
- An individual planting an attractive garden in front of his house may provide benefits to others living in the area, and even financial benefits in the form of increased property values for all property owners.
- An individual buying a picture-phone for the first time will increase the usefulness of such phones to people who might want to call him or her. When each new user of a product increases the value of the same product owned by others, the phenomenon is called a network externality or a network effect. Network externalities often have "tipping points" where, quite suddenly, the product reaches general acceptance and near-universal usage.
- Inventions and information - once an invention (or most other forms of practical information) is discovered or made more easily accessible, others benefit by exploiting the invention or information. Copyright and intellectual property law are mechanisms to allow the inventor or creator to benefit from a temporary, state-protected monopoly in return for "sharing" the information through publication or other means.
- Education leads to a more civically-minded citizenry with a greater sense of altruism, and leads to a work force that can create more wealth.
- Flu vaccinations of school children - the children themselves are unlikely to be greatly harmed by the flu, but vaccination of school children may often be the most efficient way to protect the vulnerable elderly.
- Leisure of the old - once retired, the old help younger generations undertaking several activities such as babysitting children, paying bills and cleaning the sons' house.
- Sometimes the better part of a benefit from a good comes from having the option to buy something rather than actually having to buy it. A private fire departement that only charged people that had a fire, would arguably provide a positive externality at the expense of an unlucky few. Some form of Insurance could be a solution in such cases, as long as people can accurately evaluate the benefit they have from the option.
As noted, externalities (or proposed solutions to externalities) may also imply political conflicts, rancorous lawsuits, and the like. This may make the problem of externalities too complex for the concept of Pareto optimality to handle. Similarly, if too many positive externalities fall outside the participants in a transaction, there will be too little incentive on parties to participate in activities that lead to the positive externalities.
Externalities in supply and demand
The usual economic analysis of externalities can be illustrated using a standard supply and demand diagram if the externality can be monetized and valued in terms of money. An extra supply or demand curve is added, as in the diagrams below. One of the curves is the private cost that consumers pay as individuals for additional quantities of the good, which in competitive markets, is the marginal private cost. The other curve is the true cost that society as a whole pays for production and consumption of increased production the good, or the marginal social cost.
Similarly there might be two curves for the demand or benefit of the good. The social demand curve would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit to consumers as individuals and is reflected as effective demand in the market.
Negative externalities
The graph below shows the effects of a negative externality. For example, the steel industry is assumed to be selling in a competitive market – before pollution-control laws were imposed and enforced (e.g. under laissez-faire). The marginal private cost is less than the marginal social or public cost by the amount of the external cost, i.e., the cost of air pollution and water pollution. This is represented by the vertical distance between the two supply curves. It is assumed that there are no external benefits, so that social benefit equals individual benefit.
If the consumers only take into account their own private cost, they will end up at price Pp and quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that the marginal social benefit should equal the marginal social cost, that is that production should be increased only as long as the marginal social benefit exceeds the marginal social cost. The result is that a free market is inefficient since at the quantity Qp, the social benefit is less than the societal cost, so society as a whole would be better off if the goods between Qp and Qs had not been produced. The problem is that people are buying and consuming too much steel.
This discussion implies that pollution is more than merely an ethical problem; it is more than just "greedy" and profit-maximizing firms. The problem is one of the disjuncture between marginal and social costs that is not solved by the free market. There is a problem of societal communication and coordination to balance benefits and costs. This discussion also implies that pollution is not something solved by competitive markets. In fact, a monopoly might be able to use some of its excess profits to be benevolent and internalize the externality (pay the cost of the pollution). More likely, a monopoly would artificially restrict the quantity supplied in order to maximize profits. This would actually benefit society in this situation because it would mean less pollution than in the competitive case. Perfectly competitive firms have no choice but to produce according to market incentives or private costs: if one decides to internalize external costs, it implies that this producer would incur higher costs than those of its competitors and likely be forced to exit from the market. So some collective solution is needed, such as, government intervention banning or discouraging pollution, by means of economic incentives such as taxes, or an alternative economy such as participatory economics.
Beneficial externalities
The graph below shows the effects of a positive or beneficial externality. For example, the industry supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal private benefit of getting the vaccination is less than the marginal social or public benefit by the amount of the external benefit, i.e., the fact that if one person gets the vaccination, others are less likely to get the smallpox even if they themselves are not vaccinated. This marginal external benefit of getting a smallpox shot is represented by the vertical distance between the two demand curves. Assume that there are no external costs, so that social cost equals individual cost.
If consumers only take into account their own private benefits from getting vaccinations, the market will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal social cost, i.e., that production should be increased as long as the marginal social benefit exceeds the marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the social benefit is greater than the societal cost, so society as a whole would be better off if more goods had been produced. The problem is that people are buying too few vaccinations.
The issue of external benefits is related to that of public goods, which are goods where it is difficult if not impossible to exclude people from benefits. The production of a public good has beneficial externalities for all, or almost all, of the public. As with external costs, there is a problem here of societal communication and coordination to balance benefits and costs. This also implies that pollution is not something solved by competitive markets. The government may have to step in with a collective solution, such as subsidizing or legally requiring vaccine use. If the government does this, the good is called a merit good.
Externalities and the Coase theorem
Ronald Coase argued that individuals could organize bargains so as to bring about an efficient outcome and eliminate externalities without government intervention. The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the "Coase Theorem," requires that
- Property rights are well defined;
- People act rationally
- Transaction costs are minimal
If all three of these apply, individuals will bargain to solve the problem of externalities.
Thus, this theorem does not apply to the steel industry case discussed above. For example, with a steel factory that trespasses on the lungs of a large number of individuals with pollution, it is difficult if not impossible for any one person to negotiate with the producer, and there are large transaction costs. Hence the most common approach may be to regulate the firm (by imposing limits on the amount of pollution considered "acceptable") while paying for the regulation and enforcement with taxes.
The case of the vaccinations also does not fit with the Coase Theorem. The firms of the vaccination industry would have to get together to bribe large numbers of people to have their shots. Individual firms would be tempted to "free ride" and not pay the cost of these bribes. The property rights involved are not well defined.
This does not say that the Coase theorem is irrelevant. For example, if a logger is planning to clear-cut a forest in a way that has a negative impact on a nearby resort, it is quite possible that the resort-owner and the logger could get together to agree to a deal. For example, the resort-owner could pay the logger not to clear-cut -- or could buy the forest. The most problematic situation, from Coase's perspective, occurs when the forest literally does not belong to anyone; the question of "who" owns the forest is not important, as any specific owner will have an interest in coming to an agreement with the resort owner (if such an agreement is mutually beneficial).
Also, the central government may not be needed. Traditional ways of life may have evolved as ways to deal with external costs and benefits. Alternatively, democratically-run communities can agree to deal with these costs and benefits in an amicable way.
See also
External links
- Introduction to Coase's theory by David Friedman
- Why Externalities Are Not a Case of Market Failure by Brian P. Simpson