When the person sitting next to you lights up a cigarette, he gets nicotine and the cigarette company gets some of his money. You just suffer, with no compensation. If your neighbor’s house catches fire because he fell asleep with that cigarette burning in his hand, your house may burn to the ground. The neighbor on the other side who plays very loud music late into the night—before your big economics test—enjoys the music, and the music distributors gets his money. You flunk out of college and wind up borrowing $300,000 to buy a taxi medallion. Drunk drivers, cell phones ringing in movie theaters, loud automobiles, polluted air, and rivers polluted to the point that they catch fire, like Cleveland’s Cuyahoga did, are all examples where a transaction between two parties harmed other people. These are “external effects.”
But external effects are not necessarily negative. The neighbor who plants beautiful flowers in her yard brightens your day. Another person’s purchase of an electric car reduces the smog you breathe. Your neighbor’s investment in making his home safe from fire conveys a safety advantage to you. Indeed, even your neighbor’s investment in her own education may provide an advantage to you—you may learn useful things from your neighbor. Inventions and creations, whether products or poetry, produce value for others. The creator of a poem or a mathematical theorem provides a benefit to others.
Learning Objectives
How can society stop people from doing annoying things and encourage them to do pleasing things?
These effects are called external effects, or externalities. An externality is any effect on people not involved in a particular transaction. Pollution is the classic example. When another person buys and smokes cigarettes, there is a transaction between the cigarette company and the smoker. But if you are sitting near the smoker, you are an affected party who is not directly compensated from the transaction, at least before taxes were imposed on cigarettes. Similarly, you pay nothing for the benefits you get from viewing your neighbor’s flowers, nor is there a direct mechanism to reward your neighbor for her efforts.
Externalities will generally cause competitive markets to behave inefficiently from a social perspective, absent a mechanism to involve all the affected parties. Without such a mechanism, the flower planter will plant too few beautiful flowers, for she has no reason to take account of your preferences in her choices. The odious smoker will smoke too much and too close to others, and the loud neighbor will play music much too late into the night. Externalities create a market failure—that is, a situation where a competitive market does not yield the socially efficient outcome.
Education is viewed as creating an important positive externality. Education generates many externalities, including more—and better—employment, less crime, and fewer negative externalities of other kinds. It is widely believed that educated voters elect better politicians.This is a logical proposition, but there is scant evidence in favor of it. There is evidence that educated voters are more likely to vote, but little evidence that they will vote for better candidates. Educated individuals tend to make a society wealthy, an advantage to all of society’s members. As a consequence, most societies subsidize education in order to promote it.
A major source of externalities arises in communicable diseases. Your vaccination not only reduces the likelihood that you will contract a disease but also makes it less likely that you will infect others with the disease.
Let’s consider pollution as a typical example. A paper mill produces paper, and a bad smell is an unfortunate by-product of the process. Each ton of paper produced increases the amount of bad smells produced. The paper mill incurs a marginal cost, associated with inputs like wood and chemicals and water. For the purposes of studying externalities, we will refer to the paper mill’s costs as a private cost, the cost borne by the supplier (in this case, the paper mill itself). In addition, there are external costs, which are the costs borne by third parties, that arise in this case from the smell. Adding the private costs and the external costs yield the total costs for all parties, or the social costs. These costs, in their marginal form, are illustrated in Figure 7.1.
Figure 7.1 A negative externality
Figure 7.1, the demand has been labeled “marginal benefit,” for reasons that will become apparent; but it is at this point just the standard demand, the marginal value of the product. The paper mill’s costs have been labeled marginal private cost to reflect the fact that these costs are only the mill’s costs and don’t include the cost of the bad smell imposed on others. The marginal social cost is obtained by adding the marginal external cost to the marginal private cost. The marginal external cost isn’t graphed in the figure; but the size of it is illustrated at one quantity, and it is generally the difference between marginal social cost and marginal private cost.
Left to its own devices, the paper market would equate the marginal private cost and the marginal benefit to produce the competitive quantity sold at the competitive price. Some of these units—all of those beyond the quantity labeled “Socially Efficient Quantity”—are bad from a social perspective: They cost more to society than they provide in benefits. This is because the social cost of these units includes pollution, but paper buyers have no reason to worry about pollution or even to know that it is being created in the process of manufacturing paper.
The deadweight loss of these units is shown as a shaded triangle in the figure. The loss arises because the marginal social cost of the units exceeds the benefit, and the difference between the social cost and the benefits yields the loss to society. This is a case where too much is produced because the market has no reason to account for all the costs; some of the costs are borne by others.
Figure 7.2 External costs and benefits
Figure 7.2. Streetlights are an example of a product that produces both externalities: Most of us like lighted streets, but they are terrible for astronomers. Similarly, large highways produce benefits for commuters and yet harm nearby residents.
The marginal private benefit—the benefit obtained by the buyer—and the marginal private cost give the demand and supply of a competitive market, and hence the competitive quantity results from the intersection of these two. The marginal social benefit and the marginal social cost give the value and cost from a social perspective; equating these two generates the socially efficient outcome. This can be either greater or less than the competitive outcome depending on which externality is larger.
Consider a town on a scenic bay that is filled with lobsters. The town members collect and eat the lobsters, and over time the size of the lobsters collected falls, until they are hardly worth searching for. This situation persists indefinitely. Few large lobsters are caught, and it is barely worth one’s time attempting to catch them. This sort of overuse of a resource due to lack of ownership is known as the tragedy of the commons.
The tragedy of the commons is a problem with a common resource shared by many people—in this case, the lobster bay. Catching lobsters creates an externality by lowering the productivity of other lobster catchers. The externality leads to overfishing, since individuals don’t take into account the negative effect they have on each other, ultimately leading to a nearly useless resource and potentially driving the lobsters to extinction. As a consequence, the lobster catching is usually regulated.
Key Takeaways
An externality is any effect on people not involved in a particular transaction.
Pollution is the classic negative externality.
Externalities will generally cause competitive markets to behave inefficiently from a social perspective. Externalities create a market failure—that is, a competitive market does not yield the socially efficient outcome.
Education is viewed as creating an important positive externality.
A major source of externalities arises in communicable diseases. Your vaccination not only reduces the likelihood that you will contract a disease but also makes it less likely that you will infect others with the disease.
Private costs are those borne by the parties to a transaction; external costs are costs borne by others not party to the transaction; and social costs represent the sum of private and external costs.
Private benefits are those enjoyed by the parties to a transaction; external benefits are those enjoyed by others not party to the transaction; and social benefits represent the sum of private and external benefits.
Demand is marginal private benefit; supply is marginal private cost.
The social optimum arises at the quantity where marginal social benefit equals marginal social cost. A different quantity than the social optimum creates a deadweight loss equal to the difference of marginal social benefit and cost.
The tragedy of the commons is the overuse of a resource arising because users ignore the harmful effects of their use on other users.
EXERCISES
A child who is vaccinated against polio is more likely to contract polio (from the vaccine) than an unvaccinated child. Does this fact imply that programs forcing vaccination of schoolchildren are ill-advised? Include with your answer a diagram illustrating the negative marginal benefit of vaccination, and use the horizontal axis to represent the proportion of the population vaccinated.
The total production from an oil field generally depends on the rate at which the oil is pumped, with faster rates leading to lower total production but earlier production. Suppose two different producers can pump from the field. Illustrate—using an externality diagram where the horizontal axis is the rate of production for one of the producers—the difference between the socially efficient outcome and the equilibrium outcome. Like many other states, Texas’s law requires that, when multiple people own land over a single oil field, the output is shared among the owners, with each owner obtaining a share equal to a proportion of the field under their land. This process is called unitization. Does it solve the problem of externalities in pumping and yield an efficient outcome? Why or why not?
Imagine that many students are bothered by loud music playing at 7 a.m. near their dorm. Using economic analysis, how would you improve the situation?
A local community uses revenue from its property taxes to build an expressway. Explain how this could give rise to free riders and how to solve the free-rider problem.
