In economics Economics is the social science that is concerned with the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek οἰκονομία from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)". Current, an externality (or transaction spillover) is a cost or benefit, not transmitted through prices[1], incurred by a party who did not agree to the action causing the cost or benefit. A benefit in this case is called a positive externality or external benefit, while a cost is called a negative externality or external cost.

In these cases in a competitive market, prices do not reflect the full costs or benefits of producing or consuming a product or service, producers and consumers may either not bear all of the costs or not reap all of the benefits of the economic activity, and too much or too little of the good will be produced or consumed in terms of overall costs and benefits to society. For example, manufacturing that causes air pollution Air pollution is the introduction of chemicals, particulate matter, or biological materials that cause harm or discomfort to humans or other living organisms, or damages the natural environment into the atmosphere imposes costs on the whole society, while fire-proofing a home improves the fire safety Fire safety refers to precautions that are taken to prevent or reduce the likelihood of a fire that may result in death, injury, or property damage, alert those in a structure to the presence of a fire in the event one occurs, better enable those threatened by a fire to survive, or to reduce the damage caused by a fire. Fire safety measures of neighbors.

If there exist external costs such as pollution Pollution is the introduction of contaminants into an environment that causes instability, disorder, harm or discomfort to the ecosystem i.e. physical systems or living organisms. Pollution can take the form of chemical substances or energy, such as noise, heat, or light. Pollutants, the elements of pollution, can be foreign substances or energies,, the good will be overproduced by a competitive market, as the producer does not take into account the external costs when producing the good. If there are external benefits, such as in areas of education Education in the largest sense is any act or experience that has a formative effect on the mind, character or physical ability of an individual. In its technical sense, education is the process by which society deliberately transmits its accumulated knowledge, skills and values from one generation to another or public safety Public safety involves the prevention of and protection from events that could endanger the safety of the general public from significant danger, injury/harm, or damage, such as crimes or disasters, too little of the good would be produced by private markets as producers and buyers do not take into account the external benefits to others. Here, overall cost and benefit to society is defined as the sum of the economic benefits and costs for all parties involved.[2][3]

External costs and benefits

Contents

Implications

Standard economic theory states that any voluntary exchange is mutually beneficial to both parties involved in the trade. This is because either the buyer or the seller would refuse the trade, if it won't benefit both. However, an exchange can cause additional effects on third parties. From the perspective of those affected, these effects may be negative (pollution from a factory), or positive (honey bees that pollinate the garden). Welfare economics Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine allocative efficiency within an economy and the income distribution associated with it.[citation needed] It analyzes social welfare, however measured, in terms of economic activities of the individuals that comprise the theoretical society has shown that the existence of externalities results in outcomes that are not socially optimal. Those who suffer from external costs do so involuntarily, while those who enjoy external benefits do so at no cost.

A voluntary exchange may reduce societal welfare if external costs exist. 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 may even be seen as a trespass Trespass to the person, historically involved six separate trespasses: threats, assault, battery, wounding, mayhem, and maiming. Through the evolution of the common law in various jurisdictions, and the codification of common law torts, most jurisdictions now broadly recognize three trespasses to the person: assault, which is "any act of such on their lungs The lung is the essential respiration organ in all air-breathing animals, including most tetrapods, a few fish and a few snails. In mammals and the more complex life forms, the two lungs are located in the chest on either side of the heart. Their principal function is to transport oxygen from the atmosphere into the bloodstream, and to release, violating their property rights. Thus, an external cost may pose an ethical Ethics is a branch of philosophy that addresses questions about morality—that is, concepts such as good vs. bad, noble vs. ignoble, right vs. wrong, and matters of justice, love, peace, and virtue or political Politics is a process by which groups of people make collective decisions. The term is generally applied to behavior within civil governments, but politics has been observed in other group interactions, including corporate, academic, and religious institutions. It consists of "social relations involving authority or power" and refers to problem. Alternatively, it might be seen as a case of poorly defined property rights Property is any physical or intangible entity that is owned by a person or jointly by a group of persons. Depending on the nature of the property, an owner of property has the right to consume, sell, rent, mortgage, transfer, exchange or destroy their property, and/or to exclude others from doing these things. Important widely-recognized types of, 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).

On the other hand, a positive externality would increase the utility of third parties at no cost to them. Since collective societal welfare is improved, but the providers have no way of monetizing the benefit, less of the good will be produced than would be optimal for society as a whole. Goods with positive externalities include education (believed to increase societal productivity and well-being; but controversial, as these benefits may be internalized), public health initiatives (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement. Positive externalities are often associated with the free rider problem In economics, collective bargaining, psychology, and political science, "free riders" are those who consume more than their fair share of a public resource, or shoulder less than a fair share of the costs of its production. Free riding is usually considered to be an economic "problem" only when it leads to the non-production or. 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 can refuse vaccination, still avoiding the disease 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 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.

The monetary values of externalities are difficult to quantify, as they may 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 externalities may be difficult to determine, and all parties involved may try to influence the policy responses to their own benefit. An example is the externalities of the smoking of tobacco, which can cost or benefit society depending on the situation. Because it may not be feasible to monetize the costs and benefits, another method is needed to either impose solutions or aggregate the choices of society, when externalities are significant. This may be through some form of representative democracy Representative democracy is a form of government founded on the principle of elected individuals representing the people, as opposed to autocracy and direct democracy or other means. Political economy Political economy originally was the term for studying production, buying and selling, and their relations with law, custom, and government. Political economy originated in moral philosophy. It developed in the 18th century as the study of the economies of states—polities, hence 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.

Laissez-faire In economics, laissez-faire (English pronunciation: /ˌlɛseɪˈfɛər/ , French: [lɛsefɛʁ] ( listen)) means allowing industry to be free from state intervention, especially restrictions in the form of tariffs and government monopolies economists such as Friedrich Hayek Friedrich August von Hayek CH , was an Austrian-born economist and philosopher known for his defence of classical liberalism and free-market capitalism against socialist and collectivist thought. He is considered by some to be one of the most important economists and political philosophers of the twentieth century. Hayek's account of how changing and Milton Friedman Milton Friedman was an American economist, statistician, and a recipient of the Nobel Memorial Prize in Economics. He is best known among scholars for his theoretical and empirical research, especially consumption analysis, monetary history and theory, and for his demonstration of the complexity of stabilization policy. He was an economic advisor sometimes refer to externalities as "neighborhood effects The neighbourhood effect is the tendency of a person to vote in a certain direction based upon the relational effects of the people living in the neighbourhood. The voting preference of a neighbourhood tends to be formed by consensus, where people tend to vote with the general trend of the neighbourhood. This consensus is formed by the personal" or "spillovers", although externalities are not necessarily minor or localized.

Private and social costs: Social costs are the spillover costs to society (society pays off the costs), while private costs are the costs given to the individual firms or producer.

Examples

Negative

A negative externality is an action of a product on consumers that imposes a negative side effect on a third party; (aka- Social Cost). Many negative externalities (also called "external costs" or "external diseconomies") are related to the environmental consequences of production and use. The article on environmental economics Environmental economics is a subfield of economics concerned with environmental issues. Quoting from the National Bureau of Economic Research Environmental Economics program: also addresses externalities and how they may be addressed in the context of environmental issues.

Positive

Examples of positive externalities (beneficial externality, external benefit, external economy, or Merit goods The concept of a merit good introduced in economics by Richard Musgrave is a commodity which is judged that an individual or society should have on the basis of some concept of need, rather than ability and willingness to pay. The term is, perhaps, less often used today than it was in the 1960s to 1980s but the concept still lies behind many) include:

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.

Positional

Positional externalities refer to a special type of externality that depends on the relative rankings of actors in a situation. Because every actor is attempting to "one up" other actors, the consequences are unintended and economically inefficient.

One example is the phenomenon of "over-education" (referring to post-secondary education) in the North American labour market. In the 1960s, many young middle-class North Americans prepared for their careers by completing a bachelor's degree. However, by the 1990s, many people from the same social milieu were completing master's degrees, hoping to "one up" the other competitors in the job market by signalling their higher quality as potential employees. By the 2000s, some jobs which had previously only demanded bachelor's degrees, such as policy analysis posts, were requiring master's degrees. Some economists argue that this increase in educational requirements was above that which was efficient, and that it was a misuse of the societal and personal resources that go into the completion of these master's degrees.

Another example is the buying of jewelry as a gift for another person, e.g. a spouse. For Husband A to show that he values Wife A more than Husband B values Wife B, Husband A must buy more expensive jewelry than Husband B. As in the first example, the cycle continues to get worse, because every actor positions him or herself in relation to the other actors. This is sometimes called keeping up with the Joneses.

One solution to such externalities is regulations imposed by an outside authority. For the first example, the government might pass a law against firms requiring master's degrees unless the job actually required these advanced skills.

Supply and demand diagram

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.

External costs

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.

Supply & Demand with external costs

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) is more than merely an ethical problem. The problem is one of the disjuncture between marginal private and social costs that is 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 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 (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.

Supply & Demand with external benefits

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 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.

Possible solutions

There are at least four general types of solutions to the problem of externalities:

A Pigovian tax is a tax imposed that is equal in value to the negative externality. 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. Economists prefer Pigovian taxes and subsidies as being the least intrusive and most efficient method to resolve externalities.

However, the most common type of solution is 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 setting standards, targets, or process requirements), 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 may 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.

Ronald Coase argued that if all parties involved can easily organize payments so as to pay each other for their actions, then an efficient outcome can be reached without government intervention. Some take this argument further, and make the political claim 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

If all of these conditions apply, the private parties can bargain to solve the problem of externalities.

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; 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).

See also

Notes

  1. ^ Externality vs Public Goods Hanming Fang, Duke University
  2. ^ J.J. Laffont (2008). "externalities," The New Palgrave Dictionary of Economics, 2nd Ed. Abstract.
  3. ^ Kenneth J. Arrow (1969). "The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Non-market Allocations," in Analysis and Evaluation of Public Expenditures: The PPP System. Washington, D.C., Joint Economic Committee of Congress. PDF reprint as pp. 1-16 (press +).
  4. ^ De Bandt, O.; Hartmann, P. (1998). Risk Measurement and Systemic Risk: 37–84. http://www.imes.boj.or.jp/cbrc/cbrc-02.pdf.
  5. ^ Stern, Nicholas (2006). "Introduction". The Economics of Climate Change The Stern Review. Cambridge University Press. ISBN 13: 9780521700801. http://www.hm-treasury.gov.uk/d/Part_I_Introduction_group.pdf
  6. ^ Weiss, Rick (2008-04-30). "Report Targets Costs Of Factory Farming". Washington Post. http://www.washingtonpost.com/wp-dyn/content/article/2008/04/29/AR2008042902602_pf.html.
  7. ^ Pew Commission on Industrial Farm Animal Production. "Proc Putting Meat on The Table: Industrial Farm Animal Production in America". The Johns Hopkins Bloomberg School of Public Health. http://www.ncifap.org/reports/. .
  8. ^ Liebowitz, S.J.; Margolis, Stephen E. (1994). "Network externality: An uncommon tragedy". The Journal of Economic Perspectives (American Economic Association) 8 (2): 133–150. (free version http://www.econ-pol.unisi.it/didattica/ecreti/Liebowitz-Margolis1994.pdf)
  9. ^ Glaeser, Edward L. and Shapiro (2002). "The Benefits of the Home Mortgage Interest Deduction". Social Science Research Network. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=342440.

References

External links

Categories: Environmental economics | Market failure | Welfare economics | Economics terminology

 

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