10.1 Identifying Externalities
Your decision to drive to work or to school isn’t just about you because it also affects other people. Your car is powered by energy that creates pollution when it’s produced. If it runs on gas, your exhaust spits out noxious gases, stinking up the air that others breathe. When you drive, you create traffic, slowing down other people’s commutes. Drivers are also a hazard to others, and car accidents kill over 30,000 Americans each year. Each mile you drive adds to the wear and tear on the roads, and you don’t pay directly for those repairs, but rather drivers and taxpayers as a whole are on the hook.
Driving is not just about you, because it involves an externality—a side effect on bystanders whose interests aren’t fully taken into account. Externalities are important because they lead to market failure, producing inefficient outcomes that aren’t in society’s best interest. This failure arises when there are bystanders who are affected by your choices and who can’t easily shape them. As a result, their interests are ignored or underweighted. The key insight of this chapter is that when people make decisions without facing the full consequences of their actions—that is, when externalities are involved—bad outcomes can result.
Types of Externalities
An activity whose side effects harm bystanders is called a negative externality. For instance, the exhaust that spews from your tailpipe is a negative externality because it harms others who breathe in that pollution. Alternatively, some activities involve positive externalities, which are activities whose side effects benefit bystanders. For instance, when you get a flu shot, it prevents you from getting sick, and it also protects your classmates, because if you don’t get the flu, they’re not at risk of catching it from you.
Negative externalities impose costs on others.
The following examples of negative externalities illustrate how my choices have side effects that harm you (or other bystanders):
When you stand up at a concert, you create a negative externality.
- If I stand up at a concert, you won’t be able to see the stage.
- If I smoke near you, my secondhand smoke might cause you to get cancer.
- If I take antibiotics too often, a resistant bacterial strain is more likely to form that makes antibiotics less effective for you.
- If I choose to drive a big SUV instead of a smaller hatchback, then you’re more likely to sustain a life-threatening injury if our cars collide.
- If I’m disruptive during your economics class, you’ll probably learn less.
- If I’m trolling on social media sites, you’ll find them less pleasant and less useful.
Negative externalities create problems because people often make decisions without taking full account of the costs that their choices impose on others. For example, internet trolls often think they’re engaging in harmless fun because they’re not thinking about others. But if they were forced to pay for the costs they impose on others, they might do something less annoying instead. When people fail to account for the costs their negative externalities impose, they do more of these activities than would be in society’s best interest.
Positive externalities generate benefits for others.
Positive externalities also affect bystanders, but with side effects that benefit others. The following examples illustrate some important positive externalities:
- When you plant a tree, it’ll recycle carbon dioxide into oxygen, which improves air quality for everyone in your neighborhood.
- When you buy a big-screen television for your living room, your roommates will also enjoy being able to watch movies.
- When you work hard and earn a pay rise, you’ll pay more taxes, which fund better schools, parks, and other government services that benefit your community.
- When you discover a brilliant new scientific breakthrough, other entrepreneurs might use your idea to launch their own new products.
- When you prepare before your study group meeting, your friends will benefit from your insights.
- When you exercise regularly, you’ll become healthier and your health insurer will benefit because they’ll likely spend less on your medical care.
Positive externalities sound like a good thing, since in each of these cases, your actions help other people. But they still lead to market failure because people typically make decisions without taking full account of the positive effects of their choices on bystanders. As a result, they’ll do less of these socially useful activities than is in society’s best interest. That means that even better outcomes could occur if the benefits to society were taken into account.
For example, when you decide whether to get a flu shot, you might apply the cost-benefit principle and compare the cost of the shot—say $25—with the benefit to you of a reduced chance of getting sick. If you think you’re not very likely to get the flu, you might decide to skip this year’s flu shot, reasoning that the benefit to you doesn’t exceed $25. But that might not be the best choice for your class. After all, that shot will prevent you from getting sick and it also prevents your classmates from catching the flu from you. Even if that shot isn’t worth $25 to you, the benefits to the rest of your class might mean that the benefits to you and to your class as a whole exceed the costs. Left to make the decision yourself, you might make the choice that’s in your best interest, rather than what’s in the total best interest. More generally, when people fail to account for the benefits associated with positive externalities, they do less of these activities than is in society’s best interest.
Do the Economics
Think about all of the interactions involved in your economics class. When you go to class, prep your homework, work on group assignments, and study for and take midterms, do your actions affect other people? Who? How? Do you take full account of their wishes? In other words: What are the externalities?
A price change is not an externality.
Before we move on, let’s clear up a potential misunderstanding: A price change is not an externality. For instance, consider what happens when the price of housing rises. Some people complain that higher house prices are a negative externality, because it makes life harder for new homebuyers. But they’re only thinking about half the story. The full story is that the higher price will hurt a homebuyer who has to pay more, but that harm is exactly offset by a gain to the home seller, who’ll get paid more for their house. Even if your dream home becomes so expensive that you’re priced out of the market, some other shopper will buy it instead. A price change isn’t an externality because once you total up the effects, it generates neither costs nor benefits. Price changes aren’t an externality, but rather a redistribution between buyers and sellers.
There’s another way to think about this. Externalities are about side effects on people whose interests aren’t taken into account. But potential buyers take full account of their own interests when deciding whether or how much to bid for a house. Likewise, potential sellers take full account of their own interests when deciding what price they’ll accept. Neither potential buyers nor potential sellers are bystanders—they’re the decision makers! And price changes aren’t a side effect of their actions, but rather the focus of their negotiations. Externalities are about side effects that aren’t mediated by the market, which is why they cause market failure. By contrast, when prices rise and fall in response to the actions of buyers and sellers, you’re seeing the mechanism by which markets work.
The Conflict Between Private Interest and Society’s Interest
Externalities create tension between your personal or private interest and society’s interest. Your private interest is all about the costs and benefits that you personally incur. But society’s interest includes all costs and benefits, whether they accrue to you or to others. If your choices don’t affect others, your private interest will correspond with society’s interest. But when your actions affect bystanders—that is, when there are externalities—there’s a conflict between your private interest and society’s interest. And that conflict can lead markets to fail. To see why, let’s explore how externalities shape the decisions that sellers and buyers make.
Negative externalities create external costs.
Let’s start with the negative externality caused by the production of gasoline. Refineries transform crude oil into more useful products, such as the gas that fuels your car. In Chapter 3 on supply, you discovered how an oil refinery makes decisions about how much gas to supply. Like all businesses, its supply decisions are guided by marginal cost, which is the extra cost associated with producing one more unit of output. The refinery applies the cost-benefit principle and only produces more when the price it can get for the additional gas is at least as large as the marginal cost.
But sellers like a refinery are not focusing on all the marginal costs, they are focused only on the marginal costs they pay. Let’s distinguish between two types of marginal costs. There’s the extra costs that are paid for by the seller, which are called marginal private costs. Sellers pay close attention to marginal private costs—for a refinery these include any extra oil, labor, and electricity it uses—because they directly impact their bottom line. But they don’t pay for the external cost, which is the harm that negative externalities such as pollution impose on bystanders. (They’re called external costs, because they’re imposed on folks external to those that generated them.) Because suppliers don’t pay external costs, they tend to ignore them when making supply decisions. However, each unit of a good produced with negative externalities has both marginal private costs and marginal external costs—which are the extra external costs imposed on bystanders from one extra unit.
In past chapters we’ve described a business’s supply curve as its marginal cost curve, but when managers ignore marginal external costs, we need to be more precise: The supply curve is the marginal private cost curve. Yet from society’s perspective, it doesn’t really matter whether a cost is paid by the seller or imposed on bystanders. That means from society’s perspective, the relevant marginal cost of an extra gallon of gas is the marginal social cost, which is the sum of the marginal private costs paid by the seller and the marginal external costs borne by bystanders:
Figure 1 illustrates the wedge that negative externalities can drive between the supply curve and the marginal social cost curve. Sellers are guided by their private marginal costs, and so the supply curve is also their private marginal cost curve. The marginal social cost also includes the marginal external cost. As a result, the marginal social cost curve lies above the supply curve, with the size of the wedge between them equal to the marginal external cost.
Figure 1 | Negative Externalities
Positive externalities create external benefits.
Let’s turn to a parallel analysis when there are positive externalities. For example, when you decide whether or not to get a flu shot, you are making a decision that has clear potential benefits and costs for you. If you get the shot, you’ll be more protected from the flu, but you’ll also take time out of your day, receive a not-so-pleasant shot, and you’ll pay for the shot.
In Chapter 2 about demand, you discovered that buying decisions are guided by marginal benefits, which are the benefits you get from buying one more of something. But just like sellers, buyers’ decisions are guided by the extra benefits that accrue to them, and these are called the marginal private benefit. These are the marginal gains that buyers enjoy from each unit they purchase. For a flu shot, the marginal private benefit is the protection to your own health that the shot provides.
A flu shot also creates benefits to others who are less likely to catch the flu from you. The protection that the flu shot offers those around you is an external benefit, the benefit that positive externalities create for bystanders. Each extra unit purchased of something with positive externalities has a marginal external benefit—the extra external benefit enjoyed by bystanders from the extra unit.
Because buyers don’t enjoy marginal external benefits, they tend to ignore them, or undervalue them, when making demand decisions. To be clear, if you are a caring friend, you may consider the benefit that your flu shot provides your friends. After all, when you get the flu shot, they’ll be less likely to catch the flu from you. But most people undervalue the benefits that accrue to other people, particularly people that they don’t know well. This means that they don’t consider them as much as they would if they were the ones personally enjoying them. Let’s be honest, how much do you really consider the benefit to the strangers that you may contaminate on the bus?
While previous chapters have described a buyers’ demand curve as their marginal benefit curve, it’s more precise to say that the demand curve corresponds with the buyers’ marginal private benefits. But from society’s perspective, a benefit is a benefit, whether it accrues to the buyer or to someone else. That’s why the marginal benefit that’s relevant to society as a whole is the marginal social benefit, which is the sum of the marginal benefit accruing to the buyer and the marginal external benefit:
Figure 2 shows that positive externalities drive a wedge between the demand curve for flu shots and marginal social benefits. Buyers are guided by their private marginal benefits, and so the demand curve is also the private marginal benefit curve. But from society’s perspective, there are also external benefits to consider. The marginal external benefits are included in marginal social benefits, which is why the marginal social benefit curve lies above the demand curve, and the wedge between them reflects the magnitude of the marginal external benefits.
Figure 2 | Positive Externalities
So far, you’ve seen how externalities create a wedge between what’s in society’s best interest and what’s in the best interests of sellers and buyers. Let’s now turn to considering the problems that this wedge creates.