Plain Sense Economics

Somewhat to my chagrin I discovered that I hadn’t posted on externalities – which is an economic concept important to understanding public policy options. So on with it…

In a nice, idealized market place the buyers and sellers come together at a price point where the private benefits of the purchase to the buyer equal the private gains to the seller. If, very hypothetically, I bought a cigar, and the market was performing well, the price I paid would be less than or equal to the value I place on having the cigar. The seller agrees to this same price, estimating that the price will compensate the seller for direct costs of production and opportunity costs of being in the cigar business.

So, now I own a cigar, and wish to enjoy it. Unless I do it in the middle of the woods, it is likely that someone else will be affected by my smoking the cigar. More often than not that person will be annoyed with my cigar smoking, or even harmed, health-wise. So that person has borne a cost of my cigar purchase. We call those social costs – to distinguish them from the private costs represented by the price I paid. When I bought the cigar I did not include those social costs in my calculation of whether the price was a good deal or not.

If we look at my cigar purchase from a social or community perspective, my failure to take into account the costs borne by others means that the price of the cigar is too low and that I will buy too many of them as a result. The market price in this case establishes an efficient price and quantity, but only measured in private terms. In social terms, price is too low and quantity is too high.

This cigar scenario is an example of a negative externality. A negative externality exists when there are social costs involved in a transaction in addition to any private costs.

On a larger scale industrial pollution is a good example of a negative externality. Left to pure market forces a factory that pollutes doesn’t feel those outside, social costs, and over-produces and over-pollutes.

The typical government response to a negative externality is to regulate it in some way. This can involve direct regulation, such as prohibiting smoking in public places, or requiring a factory to install pollution control equipment. There are some more market-driven examples of government intervention, including the now famous cap and trade approach found in the Kyoto Protocols and other domestic initiatives, and also including Pigovian taxes. The latter seek a way to internalize the outside costs, so that the producer/polluter must explicitly take these costs into account. The difference is that with a Pigovian tax, the polluter is free to do what they wish, and we hope that the financial incentive of the tax nudges them in the right direction.

There are positive externalities as well. These are situations where the buyer only measures their private benefit of a purchase and ignores the benefit of the purchase to others. A classic example of a positive externality is childhood vaccinations. When a family decides whether to vaccinate their child, they compare the benefit to them (increased health for their child, less worry on the part of the parents) against the cost of the vaccination. What they don’t take into consideration is that the playmates of their children also benefit from their own child’s protection. If I vaccinate Max, his playmates are better off, because someone with whom they have frequent contact is now protected and won’t spread the disease to them.

In the case of a positive externality, the family’s decision, based on private benefits and private costs will result in too few vaccinations. If we could recognize the benefits of our choice to our friends and schoolmates, then we would see more vaccinations.

Government can intervene in a market that has positive externalities in a number of different ways. They can issue direct regulations, such as requiring certain childhood vaccinations before the child can attend public school. They can also add market incentives, such as subsidizing the cost of vaccinations.

All this talk of government intervention needs a counter weight. It is possible for people to solve the problem of an externality privately. In the cigar example, there may be social pressure to smoke in seclusion, with nothing more than glares or coughs or suggestions from those bearing the outside costs. Sometimes the private solution can involve money – “I’ll pay you a certain amount of money to keep your cows from eating my vegetables.” And this talk of private solutions can take us down an interesting path – looking at when we act in altruistic ways, with no apparent compensation for our troubles. That’s the subject of a different discussion, at a later time.