The Curse of Externalities


In essence, that is an externality because the private cost of an action > the social cost. An example would be someone buying a new SUV, which has very poor mileage. The buyer’s decision to buy the SUV affects everyone on the road, yet none of these individuals had a say in his decision. He doesn’t have to compensate the asthmatic children that suffer from his excessive CO2 emissions, nor does he have to compensate the people in Bangladesh whose houses might someday be underwater due to melting ice caps, caused by his CO2 emissions. Yet all these are real costs of driving a less fuel-efficient SUV. All these are costs of buying a new SUV, but none of them have to be paid by the driver, thus they don’t affect their decision. 

When an externality is large, individuals have an incentive to do things that make themselves better off at the expense of others. In this sense, the market fails because it will do nothing to fix this problem. Instead, it encourages individuals and firms to cut corners in ways that make society worse off.

An everyday example would be people who don’t pick up after their dogs. In a perfect world, we would all carry scoopers and pick up the waste as we derive utility from behaving responsibly. But we don’t live in a perfect world, and it is easier for dog walkers to leave the waste there. The god owner weighs the costs and benefits of behaving responsibly and then decides to scoop/not scoop. But nobody speaks for the school kid running for the bus next morning, who takes one wrong step and is about to have a very bad day. 

One crucial role for governments in a market economy is to deal with externalities- those cases in which individuals or firms engage in private behavior that has broader social consequences. In all market transactions, there are voluntary exchanges that make the involved parties better off. The problem here is that not all the individuals affected by the transaction are involved in the negotiation. 

There are also positive externalities, where an individual’s behavior has positive impacts on society for which they aren’t compensated for. An example would be a beautiful building built by a private company. The workers in a city might look at that building and, but these individuals don’t pay for this utility. Similarly, a business might invest in a run-down area, consequently attracting other investment which leads to an economic regeneration, the business isn’t compensated for anchoring this revitalization. 

There are a few activities that have both positive and negative externalities. Cigarettes kill people who smoke them, pretty standard knowledge. But the smoke affects those who might be unfortunate enough to be around the smoker. Furthermore, smokers generate health costs which must be recuperated by the government. Basically, your tax money goes towards removing a part of a smoker’s lung.

At the same time, smokers do benefit us in the fact that they die early. Their pensions that they have saved their whole life are now split between the rest of us. In 2001, the Czech Republic saved $28 million a year in pensions and old-age housing and benefits, due to premature deaths from smoking. 

This is the curse of externalities. They can’t be solved by market forces because the market is the problem. 

How the government tries to cure the curse? (tbc....)