What are externalities?

In economic theory, an externality is an impact from a transaction that affects a party outside of that transaction. In a simple economic transaction the seller sets a price that reflects their costs, time, and other investment. The buyer decides if that price is at or below the perceived benefit (utility) they will get from the purchase. Standard free market forces will drive the price to an “efficient equilibrium” that will maximize utility for all parties. Simple, neat, efficient. Of course, real world transactions are rarely so simple. Nearly all purchases affect someone outside of the buyer and seller, some to a large degree.

Pollution is common example of a “negative externality”. When I buy a gallon of gas, I pay for the extraction, refining, transport, and other costs associated with making that item available to me. But when I burn it, I release a small amount of toxic chemicals into the air that have health and other impacts on those around me. The costs associated with that pollution is borne by a large number of people who had no say in the transaction. The seller and I have externalized those costs because they did not show up in the cost of the gas itself. If one could calculate the full impact of that purchase, in simple economic theory, in should be brought back into the cost of the product itself.

This was the general thinking behind many of the taxes and court judgments brought against tobacco producers in recent years. The argument is that they externalized the health costs associated with their product and profited unfairly because many costs were paid by people who did not choose to buy the product.

Of course, externalities can be positive as well. A store owner who launches an advertising campaign may benefit neighboring businesses by drawing more traffic to their shared location. Some positive externalities are not so simple or financial. A common example is in building a network. If I am the only person with a phone, it is useless. But when a second person buys one, it begins to have a potential benefit, so I have profited from their purchase. Of course, two phones in the world are still fairly useless. The network needs to grow to the point that there is a good likelihood that a person I want to call will also have a phone. As more people buy their way into the network, the value of the network to every other person increases as does the utility of their original purchase. Network externalities often have a tipping point  where they go from limited usefulness to good utility rapidly as the network achieves a critical mass of users.

Externalities can distort prices because all costs do not show up in the purchase. They also tend to cause an unfair distribution of profits (utility) to the parties that engage in the transaction. On a larger scale, they can also distort markets, development patterns, urban planning, even foreign policy. In the US, we subsidize home ownership through tax breaks. While the justification is based on the perceived positive externalities of more people owning homes, it does distort the relative prices of renting versus buying. Buying is encouraged, which increases demand for homes, spurring developments, spurring more lenders to compete for home buyers, spurring them to lower lending standards,…you see where I’m going.

Of course, part of the problem is that it’s often hard to calculate or fairly distribute the external costs. What are the externalities of a street light? Only a few people get the direct benefit of any particular light. But we all pay for the electricity, pollution, maintenance, etc. But how do you charge for a street light?

One big issue with externalities is that they tend to distort investment by forcing spending on issues that people may never have chosen to invest in. This distorts markets, leaving them in inefficient equilibriums, which in turn means that we are not maximizing utility across all parties.

I’ll be applying this concept to a lot of different issues in the future. But for now, let’s list a few possible situations and some of their unaccounted for negative (and positive) externalities.

  • Coal derived electricity – air pollution, GHG emissions, mountain top removal, jobs, cheap electricity that spurs economic growth
  • Car centric transport system – pollution, land use issues, health impacts/injuries, isolating development patterns, large financial investments that could be more efficiently invested elsewhere, personal freedom
  • Public transit & bike lanes – large financial investment by non-users, decrease in traffic congestion and pollution, better mobility for all economic levels (Note: a classic example of network issues. Large upfront investment that only begins to pay off once a critical mass is reached in usage)
  • Subsidized water – cheaper food, promotes excessive use driving up waste treatment costs, promotes planting and development planning that increase fire risk

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