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= Externality =
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Introduction
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In economics, an externality or external cost is an indirect cost or
benefit to an uninvolved third party that arises as an effect of
another party's (or parties') activity. Externalities can be
considered as unpriced components that are involved in either consumer
or producer market transactions. Air pollution from motor vehicles is
one example. The cost of air pollution to society is not paid by
either the producers or users of motorized transport to the rest of
society. Water pollution from mills and factories is another example.
All (water) consumers are made worse off by pollution but are not
compensated by the market for this damage. A positive externality is
when an individual's consumption in a market increases the well-being
of others, but the individual does not charge the third party for the
benefit. The third party is essentially getting a free product. An
example of this might be the apartment above a bakery receiving some
free heat in winter. The people who live in the apartment do not
compensate the bakery for this benefit.
The concept of externality was first developed by Alfred Marshall in
the 1890s and achieved broader attention in the works of economist
Arthur Pigou in the 1920s. The prototypical example of a negative
externality is environmental pollution. Pigou argued that a tax,
equal to the marginal damage or marginal external cost, (later called
a "Pigouvian tax") on negative externalities could be used to reduce
their incidence to an efficient level. Subsequent thinkers have
debated whether it is preferable to tax or to regulate negative
externalities, the optimally efficient level of the Pigouvian
taxation, and what factors cause or exacerbate negative externalities,
such as providing investors in corporations with limited liability for
harms committed by the corporation.
Externalities often occur when the production or consumption of a
product or service's private price equilibrium cannot reflect the true
costs or benefits of that product or service for society as a whole.
This causes the externality competitive equilibrium to not adhere to
the condition of Pareto optimality. Thus, since resources can be
better allocated, externalities are an example of market failure.
Externalities can be either positive or negative. Governments and
institutions often take actions to internalize externalities, thus
market-priced transactions can incorporate all the benefits and costs
associated with transactions between economic agents. The most common
way this is done is by imposing taxes on the producers of this
externality. This is usually done similar to a quote where there is no
tax imposed and then once the externality reaches a certain point
there is a very high tax imposed. However, since regulators do not
always have all the information on the externality it can be difficult
to impose the right tax. Once the externality is internalized through
imposing a tax the competitive equilibrium is now Pareto optimal.
History of the concept
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The term "externality" was first coined by the British economist
Alfred Marshall in his seminal work, "Principles of Economics,"
published in 1890. Marshall introduced the concept to elucidate the
effects of production and consumption activities that extend beyond
the immediate parties involved in a transaction. Marshall's
formulation of externalities laid the groundwork for subsequent
scholarly inquiry into the broader societal impacts of economic
actions. While Marshall provided the initial conceptual framework for
externalities, it was Arthur Pigou, a British economist, who further
developed the concept in his influential work, "The Economics of
Welfare," published in 1920. Pigou expanded upon Marshall's ideas and
introduced the concept of "Pigovian taxes" or corrective taxes aimed
at internalizing externalities by aligning private costs with social
costs. His work emphasized the role of government intervention in
addressing market failures resulting from externalities.
Additionally, the American economist Frank Knight contributed to the
understanding of externalities through his writings on social costs
and benefits in the 1920s and 1930s. Knight's work highlighted the
inherent challenges in quantifying and mitigating externalities within
market systems, underscoring the complexities involved in achieving
optimal resource allocation. Throughout the 20th century, the concept
of externalities continued to evolve with advancements in economic
theory and empirical research. Scholars such as Ronald Coase and
Harold Hotelling made significant contributions to the understanding
of externalities and their implications for market efficiency and
welfare.
The recognition of externalities as a pervasive phenomenon with
wide-ranging implications has led to its incorporation into various
fields beyond economics, including environmental science, public
health, and urban planning. Contemporary debates surrounding issues
such as climate change, pollution, and resource depletion underscore
the enduring relevance of the concept of externalities in addressing
pressing societal challenges.
Definitions
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A negative externality is any difference between the private cost of
an action or decision to an economic agent and the social cost. In
simple terms, a negative externality is anything that causes an
indirect cost to individuals. An example is the toxic gases that are
released from industries or mines, these gases cause harm to
individuals within the surrounding area and have to bear a cost
(indirect cost) to get rid of that harm. Conversely, a positive
externality is any difference between the private benefit of an action
or decision to an economic agent and the social benefit. A positive
externality is anything that causes an indirect benefit to individuals
and for which the producer of that positive externality is not
compensated. For example, planting trees makes individuals' property
look nicer and it also cleans the surrounding areas.
In microeconomic theory, externalities are factored into competitive
equilibrium analysis as the social effect, as opposed to the private
market which only factors direct economic effects. The social effect
of economic activity is the sum of the indirect (the externalities)
and direct factors. The Pareto optimum, therefore, is at the levels in
which the social marginal benefit equals the social marginal cost.
Externalities are the residual effects of economic activity on persons
not directly participating in the transaction. The consequences of
producer or consumer behaviors that result in external costs or
advantages imposed on others are not taken into account by market
pricing and can have both positive and negative effects. To further
elaborate on this, when expenses associated with the production or use
of an item or service are incurred by others but are not accounted for
in the market price, this is known as a negative externality. The
health and well-being of local populations may be negatively impacted
by environmental deterioration resulting from the extraction of
natural resources. Comparably, the tranquility of surrounding
inhabitants might be disturbed by noise pollution from industry or
transit, which lowers their quality of life. On the other hand,
positive externalities occur when the activities of producers or
consumers benefit other parties in ways that are not accounted for in
market exchanges. A prime example of a positive externality is
education, as those who invest in it gain knowledge and production for
society as a whole in addition to personal profit.
Government involvement is frequently necessary to address
externalities. This can be done by enacting laws, Pigovian taxes, or
other measures that encourage positive externalities or internalize
external costs. Through the integration of externalities into economic
research and policy formulation, society may endeavor to get results
that optimize aggregate well-being and foster sustainable growth.
Implications
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A voluntary exchange may reduce societal welfare if external costs
exist. The person who is affected by the negative externalities 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 may even be seen as a trespass on
their health or violating their property rights (by reduced
valuation). Thus, an external cost may pose an ethical or political
problem. Negative externalities are Pareto inefficient, and since
Pareto efficiency underpins the justification for private property,
they undermine the whole idea of a market economy. For these reasons,
negative externalities are more problematic than positive
externalities.
Although positive externalities may appear to be beneficial, while
Pareto efficient, they still represent a failure in the market as it
results in the production of the good falling under what is optimal
for the market. By allowing producers to recognise and attempt to
control their externalities production would increase as they would
have motivation to do so. With this comes the Free Rider Problem. The
Free Rider Problem arises when people overuse a shared resource
without doing their part to produce or pay for it. It represents a
failure in the market where goods and services are not able to be
distributed efficiently, allowing people to take more than what is
fair. For example, if a farmer has honeybees a positive externality of
owning these bees is that they will also pollinate the surrounding
plants. This farmer has a next door neighbour who also benefits from
this externality even though he does not have any bees himself. From
the perspective of the neighbour he has no incentive to purchase bees
himself as he is already benefiting from them at zero cost. But for
the farmer, he is missing out on the full benefits of his own bees
which he paid for, because they are also being used by his neighbour.
There are a number of theoretical means of improving overall social
utility when negative externalities are involved. The market-driven
approach to correcting externalities is to 'internalize' third party
costs and benefits, for example, by requiring a polluter to repair any
damage caused. But in many cases, internalizing costs or benefits is
not feasible, especially if the true monetary values cannot be
determined.
Laissez-faire economists such as Friedrich Hayek and Milton Friedman
sometimes refer to externalities as "neighborhood effects" or
"spillovers", although externalities are not necessarily minor or
localized. Similarly, Ludwig von Mises argues that externalities arise
from lack of "clear personal property definition."
Examples
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Externalities may arise between producers, between consumers or
between consumers and producers. Externalities can be negative when
the action of one party imposes costs on another, or positive when the
action of one party benefits another.
Classification of externalities |Consumption |Production
|Negative |Negative externalities in consumption |Negative
externalities in production
|Positive |Positive externalities in consumption |Positive
externalities in production
Negative
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A negative externality (also called "external cost" or "external
diseconomy") is an economic activity that imposes a negative effect on
an unrelated third party, not captured by the market price. It can
arise either during the production or the consumption of a good or
service. Pollution is termed an externality because it imposes costs
on people who are "external" to the producer and consumer of the
polluting product. Barry Commoner commented on the costs of
externalities:
Clearly, we have compiled a record of serious failures in recent
technological encounters with the environment. In each case, the new
technology was brought into use before the ultimate hazards were
known. We have been quick to reap the benefits and slow to comprehend
the costs.
Many negative externalities are related to the environmental
consequences of production and use. The article on environmental
economics also addresses externalities and how they may be addressed
in the context of environmental issues.
Negative production externalities
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Examples for negative production externalities include:
* Air pollution from burning fossil fuels. This activity causes
damages to crops, materials and (historic) buildings and public
health.
* Anthropogenic climate change as a consequence of greenhouse gas
emissions from the burning of fossil fuels and the rearing of
livestock. The 'Stern Review on the Economics of Climate Change' says
"Climate change presents a unique challenge for economics: it is the
greatest example of market failure we have ever seen."
* Water pollution from industrial effluents can harm plants, animals,
and humans
* Spam emails during the sending of unsolicited messages by email.
* Government regulation: Any costs required to comply with a law,
regulation, or policy, either in terms of time or money, that are not
covered by the entity issuing the edict (see also unfunded mandate).
* Noise pollution during the production process, which may be mentally
and psychologically disruptive.
* Systemic risk: the risks to the overall economy arising from the
risks that the banking system takes. A condition of moral hazard can
occur in the absence of well-designed banking regulation, or in the
presence of badly designed regulation.
* Negative effects of Industrial farm animal production, including
"the increase in the pool of antibiotic-resistant bacteria because of
the overuse of antibiotics; air quality problems; the contamination of
rivers, streams, and coastal waters with concentrated animal waste;
animal welfare problems, mainly as a result of the extremely close
quarters in which the animals are housed.".
* The depletion of the stock of fish in the ocean due to overfishing.
This is an example of a common property resource, which is vulnerable
to the tragedy of the commons in the absence of appropriate
environmental governance.
* In the United States, the cost of storing nuclear waste from nuclear
plants for more than 1,000 years (over 100,000 for some types of
nuclear waste) is, in principle, included in the cost of the
electricity the plant produces in the form of a fee paid to the
government and held in the nuclear waste superfund, although much of
that fund was spent on Yucca Mountain nuclear waste repository without
producing a solution. Conversely, the costs of managing the long-term
risks of disposal of chemicals, which may remain hazardous on similar
time scales, is not commonly internalized in prices. The USEPA
regulates chemicals for periods ranging from 100 years to a maximum of
10,000 years.
Negative consumption externalities
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Examples of negative consumption externalities include:
* Noise pollution: Sleep deprivation due to a neighbor listening to
loud music late at night.
* Antibiotic resistance, caused by increased usage of antibiotics:
Individuals do not consider this efficacy cost when making usage
decisions. Government policies proposed to preserve future antibiotic
effectiveness include educational campaigns, regulation, Pigouvian
taxes, and patents.
* Passive smoking: Shared costs of declining health and vitality
caused by smoking or alcohol abuse. Here, the "cost" is that of
providing minimum social welfare. Economists more frequently attribute
this problem to the category of moral hazards, the prospect that
parties insulated from risk may behave differently from the way they
would if they were fully exposed to the risk. For example, individuals
with insurance against automobile theft may be less vigilant about
locking their cars, because the negative consequences of automobile
theft are (partially) borne by the insurance company.
* Traffic congestion: When more people use public roads, road users
experience congestion costs such as more waiting in traffic and longer
trip times. Increased road users also increase the likelihood of road
accidents.
* Price increases: Consumption by one party causes prices to rise and
therefore makes other consumers worse off, perhaps by preventing,
reducing or delaying their consumption. These effects are sometimes
called "pecuniary externalities" and are distinguished from "real
externalities" or "technological externalities". Pecuniary
externalities appear to be externalities, but occur within the market
mechanism and are not considered to be a source of market failure or
inefficiency, although they may still result in substantial harm to
others.
* Weak public infrastructure, air pollution, climate change, work
misallocation, resource requirements and land/space requirements as in
the externalities of automobiles.
Positive
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A positive externality (also called "external benefit" or "external
economy" or "beneficial externality") is the positive effect an
activity imposes on an unrelated third party. Similar to a negative
externality, it can arise either on the production side, or on the
consumption side.
A positive production externality occurs when a firm's production
increases the well-being of others but the firm is uncompensated by
those others, while a positive consumption externality occurs when an
individual's consumption benefits other but the individual is
uncompensated by those others.
Positive production externalities
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Examples of positive production externalities
* A beekeeper who keeps the bees for their honey. A side effect or
externality associated with such 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.
* The corporate development of some free software (studied notably by
Jean Tirole and Steven Weber)
* Research and development, since much of the economic benefits of
research are not captured by the originating firm.
* An industrial company providing first aid classes for employees to
increase on the job safety. This may also save lives outside the
factory.
* Restored historic buildings may encourage more people to visit the
area and patronize nearby businesses.
* A foreign firm that demonstrates up-to-date technologies to local
firms and improves their productivity.
* Public transport can increase economic welfare by providing transit
services to other economic activities, however the benefits of those
other economic activities are not felt by the operator, it can also
decrease the negative externalities of increasing road patronage in
the absence of a congestion charge.
Positive consumption externalities
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Examples of positive consumption externalities include:
* An individual who maintains an attractive house may confer benefits
to neighbors in the form of increased market values for their
properties. This is an example of a pecuniary externality, because the
positive spillover is accounted for in market prices. In this case,
house prices in the neighborhood will increase to match the increased
real estate value from maintaining their aesthetic. (such as by mowing
the lawn, keeping the trash orderly, and getting the house painted)
* Anything that reduces the rate of transmission of an infectious
disease carries positive externalities. This includes vaccines,
quarantine, tests and other diagnostic procedures. For airborne
infections, it also includes masking. For waterborne diseases, it
includes improved sewers and sanitation. (See 'herd immunity')
* Increased education of individuals, as this can lead to broader
society benefits in the form of greater economic productivity, a lower
unemployment rate, greater household mobility and higher rates of
political participation.
* An individual buying a product that is interconnected in a network
(e.g., a smartphone). This will increase the usefulness of such phones
to other people who have a video cellphone. 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, suddenly, the
product reaches general acceptance and near-universal usage.
* In an area that does not have a public fire department, homeowners
who purchase private fire protection services provide a positive
externality to neighboring properties, which are less at risk of the
protected neighbor's fire spreading to their (unprotected) house.
Collective solutions or public policies are implemented to regulate
activities with positive or negative externalities.
Positional
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The sociological basis of Positional externalities is rooted in the
theories of conspicuous consumption and positional goods.
Conspicuous consumption (originally articulated by Veblen, 1899)
refers to the consumption of goods or services primarily for the
purpose of displaying social status or wealth. In simpler terms,
individuals engange in conspicuous consumption to signal their
economic standing or to gain social recognition. Positional goods
(introduced by Hirsch, 1977) are such goods, whose value is heavily
contingent upon how they compare to similar goods owned by others.
Their desirability is or derived utility is intrinsically tied to
their relative scarcity or exclusivity within a particular social
context.
The economic concept of Positional externalities originates from
Duesenberry's Relative Income Hypothesis. This hypothesis challenges
the conventional microeconomic model, as outlined by the Common Pool
Resource (CPR) mechanism, which typically assumes that an individual's
utility derived from consuming a particular good or service remains
unaffected by other's consumption choices. Instead, Duesenberry posits
that individuals gauge the utility of their consumption based on a
comparison with other consumption bundles, thus introducing the notion
of relative income into economic analysis. Consequently, the
consumption of positional goods becomes highly sought after, as it
directly impacts one's perceived status relative to others in their
social circle.
Example: consider a scenario where individuals within a social group
vie for the latest luxury cars. As one member acquires a
top-of-the-line vehicle, others may feel compelled to upgrade their
own cars to preserve their status within the group. This cycle of
competitive consumption can result in inefficient allocation of
resources and exacerbate income inequality within society.
The consumption of positional goods engenders negative externalities,
wherein the acquisition of such goods by one individual diminishes the
utility or value of similar goods held by others within the same
reference group. This positional externality, can lead to a cascade of
overconsumption, as individuals strive to maintain or improve their
relative position through excessive spending.
Positional externalities are related, but not similar to Percuniary
externalities.
Pecuniary
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Pecuniary externalities are those which affect a third party's profit
but not their ability to produce or consume. These externalities
"occur when new purchases alter the relevant context within which an
existing positional good is evaluated." Robert H. Frank gives the
following example:
:if some job candidates begin wearing expensive custom-tailored suits,
a side effect of their action is that other candidates become less
likely to make favorable impressions on interviewers. From any
individual job seeker's point of view, the best response might be to
match the higher expenditures of others, lest her chances of landing
the job fall. But this outcome may be inefficient since when all
spend more, each candidate's probability of success remains unchanged.
All may agree that some form of collective restraint on expenditure
would be useful."
Frank notes that treating positional externalities like other
externalities might lead to "intrusive economic and social
regulation." He argues, however, that less intrusive and more
efficient means of "limiting the costs of expenditure cascades"—i.e.,
the hypothesized increase in spending of middle-income families beyond
their means "because of indirect effects associated with increased
spending by top earners"—exist; one such method is the personal income
tax.
The effect that rising demand has on prices in marketplaces with
intense competition is a typical illustration of pecuniary
externalities. Prices rise in response to shifts in consumer
preferences or income levels, which raise demand for a product and
benefit suppliers by increasing sales and profits. But other customers
who now have to pay more for identical goods might also suffer from
this price hike. As a result, consumers who were not involved in the
initial transaction suffer a monetary externality in the form of
diminished buying power, while producers profit from increased prices.
Furthermore, markets with economies of scale or network effects may
experience pecuniary externalities. For example, when it comes to
network products, like social media platforms or communication
networks, the more people use the technology or engage in it, the more
valuable the product becomes. Consequently, early adopters could gain
financially from positive pecuniary externalities such as enhanced
network effects or greater resale prices of related products or
services. As a conclusion, pecuniary externalities draw attention
to the intricate relationships that exist between market players and
the effects that market transactions have on distribution.
Comprehending pecuniary externalities is essential for assessing
market results and formulating policies that advance economic
efficiency and equality, even if they might not have the same direct
impact on welfare or resource allocation as traditional externalities.
Inframarginal
===============
The concept of inframarginal externalities was introduced by James
Buchanan and Craig Stubblebine in 1962. Inframarginal externalities
differ from other externalities in that there is no benefit or loss to
the marginal consumer. At the relevant margin to the market, the
externality does not affect the consumer and does not cause a market
inefficiency. The externality only affects at the inframarginal range
outside where the market clears. These types of externalities do not
cause inefficient allocation of resources and do not require policy
action.
Technological
===============
Technological externalities directly affect a firm's production and
therefore, indirectly influence an individual's consumption; and the
overall impact of society; for example Open-source software or free
software development by corporations.
These externalities occur when technology spillovers from the acts of
one economic agent impact the production or consumption potential of
another agency. Depending on their nature, these spillovers may
produce positive or negative externalities. The creation of new
technologies that help people in ways that go beyond the original
inventor is one instance of positive technical externalities. Let us
examine the instance of research and development (R&D) inside the
pharmaceutical sector. In addition to possible financial gain, a
pharmaceutical company's R&D investment in the creation of a new
medicine helps society in other ways. Better health outcomes, higher
productivity, and lower healthcare expenses for both people and
society at large might result from the new medication. Furthermore,
the information created via research and development frequently
spreads to other businesses and sectors, promoting additional
innovation and economic expansion. For example, biotechnology advances
could have uses in agriculture, environmental cleanup, or renewable
energy, not just in the pharmaceutical industry. However, technical
externalities can also take the form of detrimental spillovers that
cost society money. Pollution from industrial manufacturing processes
is a prime example. Businesses might not be entirely responsible for
the expenses of environmental deterioration if they release toxins
into the air or rivers as a result of their production processes.
Rather, these expenses are shifted to society in the form of decreased
quality of life for impacted populations, harm to the environment, and
health risks. In addition, workers in some industries may experience
job displacement and unemployment as a result of disruptive
developments in labor markets brought about by technological
improvements. For instance, individuals with outdated skills may lose
their jobs as a result of the automation of manufacturing processes
through robots and artificial intelligence, causing social and
economic unrest in the affected areas.
Supply and demand diagram
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The usual economic analysis of externalities can be illustrated using
a standard supply and demand diagram if the externality can be 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.
What curve is added depends on the type of externality that is
described, but not whether it is positive or negative. Whenever an
externality arises on the production side, there will be two supply
curves (private and social cost). However, if the externality arises
on the consumption side, there will be two demand curves instead
(private and social benefit). This distinction is essential when it
comes to resolving inefficiencies that are caused by externalities.
External costs
================
The graph 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 social 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 negative externalities (such as
pollution) are 'more than' merely an ethical problem. The problem is
one of the disjunctures between marginal private and social costs that
are not solved by the free market. It is a problem of societal
communication and coordination to balance costs and benefits. This
also implies that pollution is not something solved by competitive
markets. Some 'collective' solution is needed, such as a court system
to allow parties affected by the pollution to be compensated,
government intervention banning or discouraging pollution, or economic
incentives such as green taxes.
External benefits
===================
The graph 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 (for example, society as
a whole is increasingly protected from smallpox by each vaccination,
including those who refuse to participate). This marginal external
benefit of getting a smallpox shot is represented by the vertical
distance between the two demand curves. Assume 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.
This 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
vaccination 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. Examples include policies to
accelerate the introduction of electric vehicles or promote cycling,
both of which benefit public health.
Causes
======================================================================
Externalities often arise from poorly defined property rights. While
property rights to some things, such as objects, land, and money can
be easily defined and protected, air, water, and wild animals often
flow freely across personal and political borders, making it much more
difficult to assign ownership. This incentivizes agents to consume
them without paying the full cost, leading to negative externalities.
Positive externalities similarly accrue from poorly defined property
rights. For example, a person who gets a flu vaccination cannot own
part of the herd immunity this confers on society, so they may choose
not to be vaccinated.
When resources are managed poorly or there are no well-defined
property rights, externalities frequently result, especially when it
comes to common pool resources. Due to their rivalrous usage and
non-excludability, common pool resources including fisheries, forests,
and grazing areas are vulnerable to abuse and deterioration when
access is unrestrained. Without clearly defined property rights or
efficient management structures, people or organizations may misuse
common pool resources without thinking through the long-term
effects, which might have detrimental externalities on other users and
society at large. This phenomenon—famously referred to by Garrett
Hardin as the "tragedy of the commons"—highlights people's propensity
to put their immediate self-interests ahead of the sustainability of
shared resources.
Imagine, for instance, that there are no rules or limits in place and
that several fishermen have access to a single fishing area. In order
to maintain their way of life, fishermen are motivated to maximize
their catches, which eventually causes overfishing and the depletion
of fish populations. Fish populations decrease, and as a result,
ecosystems are irritated, and the fishing industry experiences
financial losses. These consequences have an adverse effect on
subsequent generations and other people who depend on the resource.
Nevertheless, the reduction of externalities linked to resources in
common pools frequently necessitates the adoption of collaborative
management approaches, like community-based management frameworks,
tradable permits, and quotas. Communities can lessen the tragedy of
the commons and encourage sustainable resource use and conservation
for the benefit of current and future generations by establishing
property rights or controlling access to shared resources.
Another common cause of externalities is the presence of transaction
costs. Transaction costs are the cost of making an economic trade.
These costs prevent economic agents from making exchanges they should
be making. The costs of the transaction outweigh the benefit to the
agent. When not all mutually beneficial exchanges occur in a market,
that market is inefficient. Without transaction costs, agents could
freely negotiate and internalize all externalities.
In order to further understand transactional costs, it is crucial to
discuss Ronald Coase's methodologies. The standard theory of
externalities, which holds that internalizing external costs or
benefits requires government action through measures like Pigovian
taxes or regulations, has been challenged by Coase. He presents the
idea of transaction costs, which include the expenses related to
reaching, upholding, and keeping an eye on agreements between parties.
In the existence of externalities, transaction costs may hinder the
effectiveness of private bargaining and result in worse-than-ideal
results, according to Coase. He does, however, contend that private
parties can establish mutually advantageous arrangements to
internalize externalities without the involvement of the government,
provided that there are minimal transaction costs and clearly defined
property rights. Nevertheless, Coase uses the example of the
distribution of property rights between a farmer and a rancher to
support his claims. Assume there is a negative externality because the
farmer's crops are harmed by the rancher's livestock. In a society
where property rights are well-defined and transaction costs are
minimal, the farmer and rancher can work out a voluntary agreement to
settle the dispute. For example, the farmer may invest in preventive
measures to lessen the impact, or the rancher could pay the farmer
back for the harm the cattle caused. Coase's approach emphasizes how
crucial it is to take property rights and transaction costs into
account when managing externalities. He highlights that voluntary
transactions between private parties can allow private parties to
internalise externalities and that property rights distribution and
transaction cost reduction can help make this possible.
Solutions in non-market economies
===================================
* In planned economies, production is typically limited only to
necessity, which would eliminate externalities created by
overproduction.
* The central planner can decide to create and allocate jobs in
industries that work to mitigate externalities, rather than waiting
for the market to create a demand for these jobs.
Solutions in market economies
===============================
There are several general types of solutions to the problem of
externalities, including both public- and private-sector resolutions:
* Corporations or partnerships will allow confidential sharing of
information among members, reducing the positive externalities that
would occur if the information were shared in an economy consisting
only of individuals.
* Pigovian taxes or subsidies intended to redress economic injustices
or imbalances.
* Regulation to limit activity that might cause negative externalities
* Government provision of services with positive externalities
* Lawsuits to compensate affected parties for negative externalities
* Voting to cause participants to internalize externalities subject to
the conditions of the efficient voter rule.
* Mediation or negotiation between those affected by externalities and
those causing them
A Pigovian tax (also called Pigouvian tax, after economist Arthur C.
Pigou) is a tax imposed that is equal in value to the negative
externality. In order to fully correct the negative externality, the
per unit tax should equal the marginal external cost. The result is
that the market outcome would be reduced to the efficient amount. A
side effect is that revenue is raised for the government, reducing the
amount of distortionary taxes that the government must impose
elsewhere. Governments justify the use of Pigovian taxes saying that
these taxes help the market reach an efficient outcome because this
tax bridges the gap between marginal social costs and marginal private
costs.
Some arguments against Pigovian taxes say that the tax does not
account for all the transfers and regulations involved with an
externality. In other words, the tax only considers the amount of
externality produced. Another argument against the tax is that it does
not take private property into consideration. Under the Pigovian
system, one firm, for example, can be taxed more than another firm,
even though the other firm is actually producing greater amounts of
the negative externality.
Further arguments against Pigou disagree with his assumption every
externality has someone at fault or responsible for the damages. Coase
argues that externalities are reciprocal in nature. Both parties must
be present for an externality to exist. He uses the example of two
neighbors. One neighbor possesses a fireplace, and often lights fires
in his house without issue. Then one day, the other neighbor builds a
wall that prevents the smoke from escaping and sends it back into the
fire-building neighbor’s home. This illustrates the reciprocal nature
of externalities. Without the wall, the smoke would not be a problem,
but without the fire, the smoke would not exist to cause problems in
the first place. Coase also takes issue with Pigou’s assumption of a
“benevolent despot” government. Pigou assumes the government’s role is
to see the external costs or benefits of a transaction and assign an
appropriate tax or subsidy. Coase argues that the government faces
costs and benefits just like any other economic agent, so other
factors play into its decision-making.
However, the most common type of solution is a tacit agreement through
the political process. Governments are elected to represent citizens
and to strike political compromises between various interests.
Normally governments pass laws and regulations to address pollution
and other types of environmental harm. These laws and regulations can
take the form of "command and control" regulation (such as enforcing
standards and limiting process variables), or environmental pricing
reform (such as ecotaxes or other Pigovian taxes, tradable pollution
permits or the creation of markets for ecological services). The
second type of resolution is a purely private agreement between the
parties involved.
Government intervention might not always 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. Externalities
can sometimes be resolved by agreement between the parties involved.
This resolution may even come about because of the threat of
government action.
The use of taxes and subsidies in solving the problem of externalities
Correction tax, respectively subsidy, means essentially any mechanism
that increases, respectively decreases, the costs (and thus price)
associated with the activities of an individual or company.
The private-sector may sometimes be able to drive society to the
socially optimal resolution. Ronald Coase argued that an efficient
outcome can sometimes be reached without government intervention. Some
take this argument further, and make the political argument that
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 be well-defined
* People act rationally
* Transaction costs be minimal (costless bargaining)
* Complete information
If all of these conditions apply, the private parties can bargain to
solve the problem of externalities. The second part of the Coase
theorem asserts that, when these conditions hold, whoever holds the
property rights, a Pareto efficient outcome will be reached through
bargaining.
This theorem would 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 would also not
satisfy the requirements of the Coase theorem. Since the potential
external beneficiaries of vaccination are the people themselves, the
people would have to self-organize to pay each other to be vaccinated.
But such an organization that involves the entire populace would be
indistinguishable from government action.
In some cases, the Coase theorem is relevant. For example, if a logger
is planning to clear-cut a forest in a way that has a negative impact
on a nearby resort, the resort-owner and the logger could, in theory,
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, or in any example in which
there are not well-defined and enforceable property rights; 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).
However, the Coase theorem is difficult to implement because Coase
does not offer a negotiation method. Moreover, Coasian solutions are
unlikely to be reached due to the possibility of running into the
assignment problem, the holdout problem, the free-rider problem, or
transaction costs. Additionally, firms could potentially bribe each
other since there is little to no government interaction under the
Coase theorem. For example, if one oil firm has a high pollution rate
and its neighboring firm is bothered by the pollution, then the latter
firm may move depending on incentives. Thus, if the oil firm were to
bribe the second firm, the first oil firm would suffer no negative
consequences because the government would not know about the bribing.
In a dynamic setup, Rosenkranz and Schmitz (2007) have shown that the
impossibility to rule out Coasean bargaining tomorrow may actually
justify Pigouvian intervention today. To see this, note that
unrestrained bargaining in the future may lead to an underinvestment
problem (the so-called hold-up problem). Specifically, when
investments are relationship-specific and non-contractible, then
insufficient investments will be made when it is anticipated that
parts of the investments’ returns will go to the trading partner in
future negotiations (see Hart and Moore, 1988). Hence, Pigouvian
taxation can be welfare-improving precisely because Coasean bargaining
will take place in the future. Antràs and Staiger (2012) make a
related point in the context of international trade.
Kenneth Arrow suggests another private solution to the externality
problem. He believes setting up a market for the externality is the
answer. For example, suppose a firm produces pollution that harms
another firm. A competitive market for the right to pollute may allow
for an efficient outcome. Firms could bid the price they are willing
to pay for the amount they want to pollute, and then have the right to
pollute that amount without penalty. This would allow firms to pollute
at the amount where the marginal cost of polluting equals the marginal
benefit of another unit of pollution, thus leading to efficiency.
Frank Knight also argued against government intervention as the
solution to externalities. He proposed that externalities could be
internalized with privatization of the relevant markets. He uses the
example of road congestion to make his point. Congestion could be
solved through the taxation of public roads. Knight shows that
government intervention is unnecessary if roads were privately owned
instead. If roads were privately owned, their owners could set tolls
that would reduce traffic and thus congestion to an efficient level.
This argument forms the basis of the traffic equilibrium. This
argument supposes that two points are connected by two different
highways. One highway is in poor condition, but is wide enough to fit
all traffic that desires to use it. The other is a much better road,
but has limited capacity. Knight argues that, if a large number of
vehicles operate between the two destinations and have freedom to
choose between the routes, they will distribute themselves in
proportions such that the cost per unit of transportation will be the
same for every truck on both highways. This is true because as more
trucks use the narrow road, congestion develops and as congestion
increases it becomes equally profitable to use the poorer highway.
This solves the externality issue without requiring any government tax
or regulations.
Solutions to greenhouse gas emission externalities
====================================================
The negative effect of carbon emissions and other greenhouse gases
produced in production exacerbate the numerous environmental and human
impacts of anthropogenic climate change. These negative effects are
not reflected in the cost of producing, nor in the market price of the
final goods. There are many public and private solutions proposed to
combat this externality
Emissions fee
===============
An emissions fee, or carbon tax, is a tax levied on each unit of
pollution produced in the production of a good or service. The tax
incentivised producers to either lower their production levels or to
undertake abatement activities that reduce emissions by switching to
cleaner technology or inputs.
Cap-and-trade systems
=======================
The cap-and-trade system enables the efficient level of pollution
(determined by the government) to be achieved by setting a total
quantity of emissions and issuing tradable permits to polluting firms,
allowing them to pollute a certain share of the permissible level.
Permits will be traded from firms that have low abatement costs to
firms with higher abatement costs and therefore the system is both
cost-effective and cost-efficient. The cap and trade system has some
practical advantages over an emissions fee such as the fact that:
1. it reduces uncertainty about the ultimate pollution level.
2. If firms are profit maximizing, they will utilize cost-minimizing
technology to attain the standard which is efficient for individual
firms and provides incentives to the research and development market
to innovate.
3. The market price of pollution rights would keep pace with the price
level while the economy experiences inflation.
The emissions fee and cap and trade systems are both incentive-based
approaches to solving a negative externality problem.
Command-and-control regulations
=================================
Command-and-control regulations act as an alternative to the
incentive-based approach. They require a set quantity of pollution
reduction and can take the form of either a technology standard or a
performance standard. A technology standard requires pollution
producing firms to use specified technology. While it may reduce the
pollution, it is not cost-effective and stifles innovation by
incentivising research and development for technology that would work
better than the mandated one. Performance standards set emissions
goals for each polluting firm. The free choice of the firm to
determine how to reach the desired emissions level makes this option
slightly more efficient than the technology standard, however, it is
not as cost-effective as the cap-and-trade system since the burden of
emissions reduction cannot be shifted to firms with lower abatement.
Scientific calculation of external costs
==========================================
A 2020 scientific analysis of external climate costs of foods
indicates that external greenhouse gas costs are typically highest for
animal-based products - conventional and organic to about the same
extent within that ecosystem-subdomain - followed by conventional
dairy products and lowest for organic plant-based foods and concludes
that contemporary monetary evaluations are "inadequate" and that
policy-making that lead to reductions of these costs to be possible,
appropriate and urgent.
Criticism
======================================================================
Ecological economics criticizes the concept of externality because
there is not enough system thinking and integration of different
sciences in the concept.
Ecological economics is founded upon the view that the neoclassical
economics (NCE) assumption that environmental and community costs and
benefits are mutually cancelling "externalities" is not warranted.
Joan Martinez Alier, for instance shows that the bulk of consumers are
automatically excluded from having an impact upon the prices of
commodities, as these consumers are future generations who have not
been born yet. The assumptions behind future discounting, which
assume that future goods will be cheaper than present goods, has been
criticized by Fred Pearce and by the Stern Report (although the Stern
report itself does employ discounting and has been criticized for this
and other reasons by ecological economists such as Clive Spash).
Concerning these externalities, some, like the eco-businessman Paul
Hawken, argue an orthodox economic line that the only reason why goods
produced unsustainably are usually cheaper than goods produced
sustainably is due to a hidden subsidy, paid by the non-monetized
human environment, community or future generations. These arguments
are developed further by Hawken, Amory and Hunter Lovins to promote
their vision of an environmental capitalist utopia in 'Natural
Capitalism: Creating the Next Industrial Revolution'.
In contrast, ecological economists, like Joan Martinez-Alier, appeal
to a different line of reasoning. Rather than assuming some (new)
form of capitalism is the best way forward, an older ecological
economic critique questions the very idea of internalizing
externalities as providing some corrective to the current system. The
work by Karl William Kapp argues that the concept of "externality" is
a misnomer. In fact the modern business enterprise operates on the
basis of shifting costs onto others as normal practice to make
profits. Charles Eisenstein has argued that this method of privatising
profits while socialising the costs through externalities, passing the
costs to the community, to the natural environment or to future
generations is inherently destructive. Social ecological economist
Clive Spash argues that externality theory fallaciously assumes
environmental and social problems are minor aberrations in an
otherwise perfectly functioning efficient economic system.
Internalizing the odd externality does nothing to address the
structural systemic problem and fails to recognize the all pervasive
nature of these supposed 'externalities'. This is precisely why
heterodox economists argue for a heterodox theory of social costs to
effectively prevent the problem through the precautionary principle.
Further reading
======================================================================
* Anderson, David A. (2019) 'Environmental Economics and Natural
Resource Management 5e',
[https://www.routledge.com/Environmental-Economics-and-Natural-Resource-Management-5th-Edition/Anderson/p/book/9780815359036]
New York: Routledge.
* Berger, Sebastian (2017) The Social Costs of Neoliberalism: Essays
in the Economics of K. William Kapp. Nottingham: Spokesman.
* Berger, Sebastian (ed) (2015) The Heterodox Theory of Social Costs -
by K. William Kapp. London: Routledge.
*
* Johnson, Paul M. [http://www.auburn.edu/~johnspm/gloss/externality
Definition] "A Glossary of Economic Terms"
*
*
*
*
*Jean-Jacques Laffont (2008) Externalities. In: Palgrave Macmillan
(eds) The New Palgrave Dictionary of Economics. Palgrave Macmillan,
London
External links
======================================================================
* [http://www.externe.info/ ExternE - European Union project to
evaluate external costs]
*
[https://web.archive.org/web/20120417114127/http://www.csc.noaa.gov/digitalcoast/socialcoast/econ120/
Econ 120 - Externalities]
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=========
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Original Article: http://en.wikipedia.org/wiki/Externality