Positive+and+Negative+externalities

Economic Externalities
Dan Reichart

Externalities, in the economic sense, are defined as "third party (spillover) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid." Note that this definition allows for the existence of both __positive__ and __negative__ externalities, even though most material I found dealt almost exclusively with the negative.

Since I tend to like the positive side of things, let me start there.

Positive Externalities
Back in 1977, the Trans-Alaska Pipeline was opened and began pumping the first of what is now more than 15 billion barrels of crude oil through its 800 plus mile stretch of pipe. At the time of the opening, there was great concern for the environmental hazards posed by such a pipeline. The caribou, for example, used a portion of the pipeline route as a breeding ground and an invasion like the pipeline was thought likely to disrupt the mating practices of the caribou, which would lead to a reduction, possibly an extinction, of the species.

Fast forward to 2006, when Walter Hickel, a former US Secretary of the Interior and Governor of the state of Alaska was quoted as saying that the Alaska caribou herd:

//"...has not only survived, but flourished. In 1977, as the Prudhoe region started delivering oil to America's southern 48 states, the Central Arctic caribou herd numbered 6,000; it has since grown to 27,128."//

The growth in the caribou population has been directly linked to the warmth generated by the oil that moves through the pipeline. The warmth attracts more caribou to a smaller area, which leads to easier "hookups" among the members of the herd, which then leads to a growth in population.

This unexpected consequence of the Trans-Alaska Pipeline is an example of a positive externality. The caribou get no gain from the oil being pumped from Alaska to the rest of the United States. But they do gain from the fact that the oil is being pumped. Since they do not pay for the gain they experience, the caribou participate in the "spillover" effect, which is the definition of externalities given above.

A more recently highlighted example of a positive externality was in the news this past spring and summer. The honey bee population was inexplicably shrinking and the consequences of that occurrence were discussed in the media. What was being explained by the media were the positive externalities of honey bee hives, which pollinate several food crops and allow them to produce the food that we all rely upon. In most cases, these hives are not raised with pollination of crops in mind, rather they are raised to produce honey. But pollination of crops is a positive externality from which we all derive benefit.

Negative Externalities
The classic example of a negative externality, and one that has gotten alot of attention in the past few years, is the pollution generated by factories. When a factory produces any product, there is invariably some generation of waste. We all deal with that waste to some degree, be it by breathing polluted air, paying to clean dirty water through our taxes, etc. Many people even believe that the carbon dioxide emissions from factories is leading to a global temperature increase, which could have devastating long-term effects on virtually all forms of life on earth. But the bottom line on all of this is that we are not paying for, or being compensated for, any of these effects. We may derive a direct benefit from the product being produced or from a job that we have in the factory. But the negative effects of the waste that is generated are another "spillover" effect of a process designed for an entirely different purpose. In terms of this discussion, they constitute a negative externality.

Externalities and Economics
So now that we have a definition of externalities and have seen some examples, what does it all mean in the study of economics?

Mathematically, one could express externalities as follows:


 * Social Cost = Private Cost + Externality**

In other words, the full cost of producing a product (social cost) should consider both the basic costs of production (private cost) and the cost of impact on outsiders (externality). When a company fails to take the full cost into consideration (as most do) the result can be considered to be an inefficient allocation of resources. This is because the company is not getting the full payment for the benefits it provides, or is not making the full payment of the resources it uses in production. In either case this situation defined as a market failure.

Externalities and Market Failure
Market failure occurs when the socially optimal output differs from the output that a firm might generate in order to maximize profits. Put another way, a profit maximizing firm would produce at a level where its (private) marginal costs are equal to its (private) marginal revenue. However, the socially optimal output would be at a level where (social) marginal costs are equal to (social) marginal benefit. When those two levels differ, the result is market failure.

As you can see from the graph, this example shows us a situation where the profit mazimizing supply differs from the supply needed to be socially optimal. That means that market failure has occurred. For most companies, the real danger in an environment of market failure lies in the effort of some, especially politicians, to "fix" the failure. Through further regulation, additional taxes or other means, many politicians see an opportunity to right a percieved wrong when they pass legislation designed to fix the failures in a market. This, in most cases, adds to the cost of doing business and could lead to some participants leaving an otherwise profitable situation. The result, in many cases, is reduced output and higher prices, which may be what is called for in an effort to achieve the socially optimal level of output.

Economists differ on their opinion of government intervention to fix market failure and good arguments can be made for both sides. Pro interventionists argue that the social good outweighs the concerns of what might happen to an individual company and the argument for limiting pollutants is an example of where most of society might benefit. On the other hand, non interventionists argue that the fix might be worse than the problem and that excessive regulation leads to fewer jobs and less competition.

I don't know who is right. But I do know that companies are beginning to look at externalities more closely. In the long run, I think we will all benefit from a closer look at total cost and impact through more innovation and more efficient production processes. Who knows, it might even reduce government regulation by staying a step ahead. And in the end, that would be the free market working to solve its own problems.

Multiple Choice Questions
1. Externalities are always negative to society. A. True B. False

2. When a firm maximizes its profits, they are always producing at the socially efficient level. A. True B. False

3. Externalities, both negative and positive, are a cause for... A. Concern B. Market Failure C. Full Employment D. Monopolistic Competition

4. Externalities are defined as... A. The "spillover" effect from production or consumption of goods and services B. Government regulations, which limit the number of people a firm can hire C. Competitors actions, which cause a firm to have to respond D. Lawn maintenance at the factory

5. All economists agree that the government should intervene to fix market failure. A. True B. False

Answers
1. B - Externalities can be either positive or negative, like the example of the honey bees. 2. B - When a firm maximizes profits, they produce at the level that is best for the firm. It may or may not be best for society. 3. B - Externalities are an inidication of inefficiency in the market. This is the definition of market failure. 4. A - When someone gets something that was not intended for them, it could be deemed "spillover." 5. B - Economists disagree on whether or not the government should interfere with the markets.