Externalities: When the Private Market Fails Us

Externalities are one of the most fascinating subjects in public policy and economics. Technically, economists define an externality as an action by one party that affects another party in a manner that is not accounted for by the market. Blah, blah, blah, blah, blah. What this really means is that one someone does something, they don?t have to pay for ALL the consequences, good or bad. The implications are huge. Because one person is not paying for all their actions, part of the costs or benefits are external to the market. Because of this, there are whole sections of the economy where society is not getting enough of some things and too much of others. Externalities provide a prime example of when markets can fail, and why government intervention is warranted. Let?s start with a common example given in every Econ 101 class?pollution.

When ACME Electricity Company generates power, they burn coal to heat water, to create steam, to move turbines, which creates electricity to power my laptop, so I can write this entry. These are all really good things Smokestack billows an externality (New Yorkers will certainly remember what happens when there is no electricity, as during last summer?s blackout), and I like them so much, I pay for them?to the tune of $70 per month, or so. This is all an economic wash as far as overall welfare is concerned. I pay $70, and I get $70 worth of electricity. ACME spends $70 generating electricity, and they give up that much power to me. In addition, if generating electricity gets more expensive, I pay more, and if it gets cheaper, I pay less or ACME gets higher profits. The point is that the market accounts for all the good and bad parts of this transaction through the price of electricity. Something else happens, however, when ACME burns the coal to make me some more electricity, they release black smoke into the atmosphere. This black smoke kills off some of the cherry blossoms that grow in Prospect Park that my friend Ian really likes to look at. Let?s carefully look at the implications of this: some transaction that I have entered into has created a lower level of welfare for Ian, and, this is the point, I don?t pay for Ian?s lessened lifestyle.

This small point has huge implications on a large scale. Since I don?t have to pay for Ian not being able to see as many cherry blossoms, I don?t take this into account when I make a decision on how much electricity to buy and, consequently, how much to pollute Prospect Park. The result is that there is an overprovision of electricity and too much pollution as far as society is concerned. The total cost, Ian?s lower welfare plus my $70, is greater than the $70 worth of benefit to me by a net of Ian?s lower welfare. Pollution externalities find there way into all sorts of public policy debates: how much we choose to drive, littering, and how loud we play or radios at night are all examples of different forms of pollution. It is highly important to note as well, that externalities can be positive as well as negative. One example is education. When a person chooses to pay for a college degree, they are presumably going to get the benefits of that degree in forms of higher wages, better job satisfaction, increased self-esteem, the great experiences, etc. There are however, also benefits that they pay for that society gets. These benefits might include lower crime because educated people have more access to money, more technological innovation for society, better run companies, and better run governments, and anything else we get from a more educated society. Since these benefits are external to the price you pay for your private benefit to education, there is, in this case, an under provision of education (as opposed to too much electricity in the case of a negative externality). It is this under provision of education that provides the rationale for a good public school system.

So, what do we do as a society if the market fails to provide us enough of these public benefits or too much the public costs. The solution is one of the economic roles for government, since the market cannot provide the best solution for society (that?s right there is not a real economist anywhere who says that governments should be abolished). We?ll cover more of this when we go over the Coase Theorem, but the general idea is that the external cost (or benefit) must be internalized into the price of the private cost (or benefit). We do this in different ways. One way is to measure the value of the Cherry Blossoms to Ian, and charge me through a tax or user fee that amount. Because I am now paying for Ian?s disutility, I will reduce my consumption of electricity to the socially optimal level; this type of user fee is well represented by the gasoline tax.

Another way to internalize the cost is a merger. If Ian were in include me in his Blossom viewing activities, his disutility would become mine too?he is, after all, my friend. Since his pains are now mine, I would incorporate them into my costs and pollute less. We could use social convention. Neighborhood associations who want to keep their property values up often use this method. Since my neat yard gives me a private benefit, but also gives the rest of a neighborhood a benefit, snooty neighbors are using social convention for the benefits of the public good. Finally, we could regulate the amount of a negative or positive. ACME can only pollute this much, or every child must go to school until age 16.

These responses, and all the others I left out, are a public finance textbook all unto themselves, but hopefully you can see the idea of how to begin to solve the problems associated with externalities. All of these solutions are fraught with problems of efficiency, equity, and measurement, but a brief look at the theory at least lets us begin to explore one of the most fascinating topics of public policy.