Externalities 101

We economists are often faulted for having a language all our own, usually unintelligible to common mortals. (To be fair, our discipline is not unique in this: many think the language of lawyers is worse and academics of other disciplines are no different when engaging in discussions within their respective rarefied realms.) Today I have chosen to focus on a term often heard from economists, but I suspect not generally understood by all.  I refer to “externalities,” examples of which we encounter routinely in our daily lives (I cite two examples below that are currently hot policy issues).  The reason they are so important is that they are an important source of market failure; that is, they provide one major instance when market forces left alone will fail to provide an efficient outcome a la the “invisible hand” postulated by Adam Smith.  They also give a prime illustration of the economic principle that inspired the name of this column: that there’s no such thing as a free lunch.

When firms produce goods or services, they incur costs.  How much these costs influences their decision on how much to produce to gain the most profit, after weighing them against the price of the product.  Similarly, when we consumers purchase goods and services, how much of them we buy depends on the level of benefits they give us, relative to the cost of obtaining them, i.e., their price.  Our decisions on how much to produce or consume ultimately comes out of a comparison of costs and benefits.  That, by the way, is really what economics is all about. It’s about deciding how much to produce or consume to maximize net benefits, represented by profits for the producer, and by satisfaction or happiness for the consumer.

The problem is that the costs and benefits faced by one person or firm (private costs and benefits) are often not the same as those faced by society (social costs and benefits).  When a cement manufacturer pollutes a waterway as it produces cement, he imposes a cost on those around without necessarily feeling the same cost himself—an external cost, or externality, not felt by the firm itself.  Unless the government imposes an additional tax to charge him for the harm imposed on others (or unless forced to spend the additional amount needed to clean up the wastewater before dumping it), the firm considers only its direct production costs in finding its profit-maximizing output level.  And because the private costs are less than the social costs (which includes the external costs imposed on others due to pollution on top of the firm’s private costs), the firm will end up producing too much cement, and with it, too much pollution, than is best for society as a whole.

A prominent example in an industry subject to so much acrimonious debate is the environmental damage caused by mining activities, through destruction of biodiversity, chemical contamination of waterways and groundwater, or loss of topsoil through erosion.  There are also social costs when communities are displaced and cultural assets compromised as a result of mining operations in traditional ancestral domains.  If society is to find the optimal level of mining activity that comes out of a full accounting of benefits and costs, mining enterprises have to “internalize” the full costs incurred by society in the course of their operations.  Large firms often do this voluntarily, by spending amounts to avoid or compensate for most of the external costs.  Otherwise, government must make them internalize these externalities by charging them commensurate fees or taxes.  Thus, these externalities must be part of the calculation of how much the state must obtain from mining firms by way of taxes, royalties and charges.  Critics of our current mining policies maintain that under current rules, they are not.

Externalities need not be negative.  When your neighbor buys a wi-fi router that you can “ride on” and gives you free Internet access yourself, you are enjoying a positive externality, an external benefit.  When you repaint your house and this makes your neighborhood more pleasant for everyone else, you have caused a positive externality.  When the old historic houses in Vigan were restored by their private owners, the benefits went well beyond the private owners.  Thus, the local government was justified in granting tax incentives to the private owners who did so; this allowed them to “internalize” the benefits they caused on other Vigueños.

Mass transport systems are another example. When people decide to take the MRT rather than their cars, they help decongest city traffic, thereby causing an external benefit to society at large.  An efficient mass transport system thus benefits society as a whole, more than the sum of the benefits of individual riders combined.  This positive externality justifies the partial subsidy enjoyed by MRT riders through fares that do not reflect the full costs of the service.  The debate on this raging issue is not on whether MRT rides should be subsidized or not—no doubt they should be—but the real issue is by how much.  The answer requires a good estimate of the peso value of the positive externality caused by every MRT rider.  Economists have ways to do this; one may estimate all the attendant costs of traffic delays, for example, and consider this the avoided cost (thus additional benefit) when people ride the MRT.  Similarly, determining the appropriate share of government in mining revenues will require estimating the value of all external costs involved in mining.

I guess that’s why economists will never run out of work.

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E-mail: cielito.habito@gmail.com