Externalities & Decision-Making
Basic Intro to Decision-Making While Factoring in Externalities
Hello!
Thank you for reading the Brainwaves newsletter. I’m Drew Jackson, your content curator, and today I’m writing about positive and negative externalities. Let’s dive in.
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Credit ZDNET
Thesis: Externalities are present throughout every part of the economy, yet when consumers and businesses make decisions, externalities are rarely considered. If considered, the world would probably make very different choices on how to allocate resources, time, and effort.
Economic Externalities
Consumption, production, investment, and other economic decisions often affect people not directly involved in the transactions. These indirect effects are called externalities. To rephrase, an externality is a cost or benefit that is caused by one party but incurred or received by another party. It’s an event occurring as a byproduct of another event occurring.
What types of externalities are there?
Technical Externalities: The indirect effects of these decisions have an impact on the consumption and product opportunities of others, but the price of the product/service does not take those externalities into account. For example, a company produces a product, yet produces pollution at the same time, however, the pollution effect on society is not felt through the price of the product.
Pecuniary Externalities: The indirect effects of these decisions have an impact on the prices of goods or services external to those decisions. For example, if a company builds a new factory near a residential area, it might increase demand for housing and drive up the prices for new residents.
Inframarginal Externalities: The indirect effects of these decisions affect consumers or producers who are not at the margin of the market. For example, if a new technology reduces the cost of producing a good, it might benefit all consumers, including those who were already buying the good at the original price.
Network Externalities: The indirect effects of these decisions occur when the value of the good or service depends on the number of other people using it. For example, social media platforms have network externalities because they become more valuable as more people join.
Where do externalities come from?
Production Externality: An externality created when something is made/produced
Consumption Externality: An externality created when something is used/consumed
As implied, externalities can be positive or negative, creating a positive or negative effect on society.
Credit Shutterstock
Negative Externalities
Negative externalities are scenarios in which one party’s actions make a third, independent party worse off, yet the original party does not bear the costs of doing so. Examples of negative externalities are below:
Examples of Negative Production Externalities
Pollution: Factories releasing toxic chemicals into rivers or burning fossil fuels that contribute to greenhouse gases
Noise Pollution: Loud factories, construction sites, or transportation systems can negatively affect the quality of life for nearby residents
Traffic Congestion: Increased traffic due to economic activity can lead to longer commute times and higher fuel consumption
Depletion of Natural Resources: Overexploitation of natural resources can have long-term consequences for ecosystems and future generations
Examples of Negative Consumption Externalities
Second-Hand Smoke: Smoking in public places can harm those exposed to secondhand smoke
Littering: Littering can make public places unsightly, harm wildlife, and increase cleanup costs
Overconsumption: Excessive consumption of goods/services can contribute to environmental degradation and resource depletion
Other Examples of Negative Externalities
Crime: Higher crime rates can impose costs on society through property damage, healthcare expenses, and reduced quality of life
Overcrowding: Overcrowding can strain infrastructure and resources, leading to higher costs for everyone
Credit ThoughtCo
Positive Externalities
Positive externalities are scenarios in which one party’s actions make a third, independent party better off, yet the original party does not bear the costs of doing so. Examples of positive externalities are below:
Examples of Positive Production Externalities
R&D: R&D investments can lead to technological advancements that benefit society as a whole
Education: Education can have long-term benefits for society, including increased productivity, reduced crime rates, and improved health outcomes
Infrastructure: Investments in infrastructure can improve economic efficiency and quality of life for those around the infrastructure and those using it
Environmental Conservation: Protecting natural resources and preserving biodiversity can have benefits for society (e.g., improved air and water quality, climate regulation, recreational opportunities).
Examples of Positive Consumption Externalities
Vaccination: Vaccinations help prevent the spread of infectious disease throughout entire communities
Arts and Culture: Art and culture can enrich the lives of individuals and communities by promoting creativity, diversity, and social cohesion
Recycling: Recycling helps conserve resources, reduce pollution, and create jobs
Other Types of Positive Externalities:
Network Effects: Some goods and services become more valuable as more people use them
Knowledge Spillovers: Knowledge and technology sharing can lead to innovation and economic growth
Remote Work: Remote work shifts helped alleviate air quality and traffic congestion
Credit Medium
Solutions to Externalities
Economists have tried to propose solutions to externalities for decades, with some being better than others.
Solutions to Discourage Negative Externalities
Taxing Consumer Behavior: Taxes can be imposed to reduce the harmful effects of certain externalities (called Pigovian tax, named after economist Arthur C. Pigou). A tax will equal the cost of the externality, meant to discourage activities that cause harmful effects. For example, if you wanted to buy a product that was produced with an externality of pollution, you would have to pay an extra pollution tax when buying the product.
Laws and Regulations: Laws and regulations put in place can strictly prohibit activities in which there is an especially negative externality or when there is a need for an immediate response to a negative externality. For example, a government seeking to eliminate the negative externalities associated with pollution can pass regulations limiting any type of manufacturing that produces pollution.
Property Rights: Putting property rights in place will create fear as people will be wary of possible legal action against them.
Product Labeling: Labeling products with information about their environmental impact can help consumers make informed choices and encourage businesses to adopt more sustainable practices. For example, companies can advertise their products are made of 100% recycled material to encourage consumers to purchase their product over others, eventually shifting demand away from products with negative externalities.
Technological Innovation: Investing in R&D can lead to developing new technologies that reduce or eliminate negative externalities. For example, a company may invest in R&D to develop a new manufacturing process that eliminates the byproduct of pollution.
Education and Awareness: Raising public awareness about the negative consequences of certain activities can encourage individuals and businesses to change their behavior. For example, educating people on the negative externalities of unsustainably farmed meat will shift demand away from these products.
Solutions to Encourage Positive Externalities
Subsidies: Government subsidies encourage the consumption of a positive externality as additional incentives are present to motivate this behavior. Subsidies can also be placed on an item to detract from the opposite activity (e.g. government incentives on energy-efficient renovations discouraging consumers against options with more externalities).
Tax Breaks: Offering tax incentives can reduce the costs associated with activities that generate positive externalities. For example, tax breaks for businesses that invest in environmentally friendly practices can promote sustainability efforts.
Government Mandates: Governments can mandate certain activities that generate positive externalities. For example, governments can require vaccinations to help prevent the spread of diseases.
Direct Provisions of Public Goods: Governments can directly provide goods/services that generate positive externalities. For example, governments can provide public parks, libraries, museums, and other public goods that have positive externalities to the community.
Education and Awareness: Raising public awareness about goods and services with positive externalities can encourage individuals and businesses to support these activities.
Technological Innovation: Investing in R&D can lead to the creation of new technologies that generate positive externalities.
Overall, externalities are one of the main reasons governments involve themselves in the economy—through taxation, subsidies, regulations, and more.
Credit Corporate Finance Institute
Examples of Externalities in 2024
Externalities are often easier to understand through examples. Here are some issues and topics particularly relevant to externalities in 2024, exhibiting positive and negative externalities:
Externalities of Cryptocurrency Mining
Recent advances in the popularity of cryptocurrency and cryptocurrency mining have led to many unforeseen externalities. Some of these externalities include high energy consumption, electronic waste from mining hardware becoming obsolete quickly, and the potential strain on local power grids in areas with large mining operations.
Cryptocurrency mining has led to some positive externalities, including R&D into more efficient computing and energy solutions, economic opportunity, and access to financial services for those who potentially don’t use other methods.
Externalities of Misinformation
Misinformation has spread exponentially across various social media entities in the last decade. This has led to an erosion of trust in institutions and other reliable information sources, political polarization, social division, and other risks associated with the spread of false information.
Efforts to combat misinformation have led to improved digital literacy programs and critical thinking skills in some parts of the country, with increased fact-checking efforts, and technological advancements for detecting false information.
Externalities of Fast Fashion
Fast fashion has become a global fad, with many companies capitalizing on the recent trends to achieve billion-dollar valuations. Yet, there have been some missteps along the way. Environmental pollution has been emitted from textile production and disposal, workers have been exploited and are often in unsafe locations, natural resources have been rapidly depleted, and the throwaway consumer culture has increased in popularity. These efforts, however, have made trendy clothing more accessible to lower-income consumers. In some manufacturing countries, fast fashion has contributed to economic development.
Externalities of Consumer Choices
Consumer choices often have negative and positive externalities. For instance, consumer choices can encourage the exploitation of workers as consumers demand cheaper products. Pressure to keep costs low can discourage the formation of unions or implementation of worker protections. These workers, however, can lead to large-scale economic development in their subsequent countries and allow the workers to gain valuable skills and experience.
Externalities of Ride-Sharing Services
Ride-sharing services such as Uber or Lyft were heralded as providing a better, cheaper solution than traditional taxis. Yet, these service providers have led to job insecurity as drivers often lack traditional employees' benefits and job protections. In contrast, these services have increased access to rides and offer flexible work options for people who are in need.
Credit X/Twitter
Everyone Should Consider Externalities
We as humans rarely understand and acknowledge some of the psychological aspects related to externalities. For instance, we tend to ignore negative externalities in our daily decisions. What are the negative externalities associated with throwing that can into the trash and not the recycling bin 3 feet away? What are the negative externalities associated with driving instead of using public transportation? What are the negative externalities associated with buying this piece of clothing from a massive retail chain vs. buying a piece of clothing from the local vendor down the street?
The last thing I’ll touch on today is the concept of framing: Framing refers to the way information is presented to people. How an issue is framed can significantly influence public opinion and policy decisions.
Some examples are the following:
Gain vs. Loss: People are generally more risk-averse when it comes to losses. If the benefits of addressing an externality are framed as a gain (e.g., cleaner air, healthier communities), it may be more appealing than framing it as avoiding a loss (e.g., preventing disease, avoiding climate change).
Attributes: The specific attributes of an externality can influence our perception. For example, framing pollution as a threat to human health might evoke a stronger emotional response than framing it as an environmental issue.
Responsibility: Assigning responsibility for an externality can shape public opinion. If a specific group or industry is identified as the cause of an externality, it can increase pressure on them to take action.
Proximity: The proximity of an externality can affect our concern. We may be more likely to care about externalities that directly affect us or our communities.
To conclude, many people are familiar with Isaac Newton’s Third Law: For every action, there is an equal and opposite reaction.
Although this is from a scientific & physics context, it can frame the backbone for our version specific to externalities:
For each action, there is a positive externality, negative externality, or both positive and negative externalities associated with it. As humans, we should be constantly looking for these externalities and understand how they would affect our decisions.
See you Saturday for The Saturday Morning Newsletter,
Drew Jackson
Twitter: @brainwavesdotme
Email: brainwaves.me@gmail.com
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