Externalities in Economics

Externalities in Economics:

Externalities are pervasive and significant phenomena in modern societies. The term externalities refers to the economic effects which occur from the production or the use of goods by other parties or economic units. It is said that Public goods and externalities are not unrelated. In other words, Public goods and externalities are related. Externalities may affect a large number of people in a uniform manner, in which case the externality is essentially a public good (or public bad). Let us know explain, how externalities occur as public good or public bad.

Education increases the skills and general welfare of the person being educated and may in addition, make the person a better citizen. That is, the person’s behavior in the political process may be more wise and informed, and an informed may make better political decisions. Since, such decisions affect everyone, the education of each person produces an external benefit that accrues to the members of the community and the nation in which the person resides. This external benefit is a public good that is jointly produced along with the private goods (marketable skills) resulting from education.

Similarly, air pollution is generated by iron mill smoke and the exhaust of automobiles are public bads that are produced jointly with private goods (iron mills, and private transportation). Again, the railway uses a lot of coal in firing steam locomotives putting the residential and other area’s near the railway loco sheds to a lot of suffering on account of the smoke nuisance. These are the cost to society, but not to the individual undertaking.

In the above examples, public goods, i.e., benefits and public bads that are produced with private goods are known as externalities. These are the cost to society, but not the individual undertaking. This cause a divergence between private cost (internal cost) and social marginal cost or external cost or benefit, of the good in question. The market takes into account internal costs, and not the social marginal cost or external cost (or benefit) of the good in question. Consumers reveal their preferences for the benefits which are wholly internalized (rival), but not for the external benefits, i.e., purification of air (non-rival). Thus, the market fails to achieve an efficient allocation of resources when externalities are present.

To be more clear, let the production of a commodity, say iron, generate air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus has two components:

• the cost of the labor, machines, iron ore, coal, and other inputs directly required to produce the iron.
• The costs are borne by the members of the community in the form of air pollution damages.

The market takes into account the first component of the above costs but not the second. This is the cause of the divergence between private cost (internal cost) and the social marginal cost (external bads). Hence, the market fails to achieve an efficient allocation of resources when externalities, i.e., external costs or benefits are present.

It should also be made clear here that some externalities can also be private good and bad. The dandelion seeds that below from my lawn to my neighbors are a negative externality and a private bad because this bad is not available to other members of the community once the seed settles in my neighbor’s lawn. Similarly, honey produced from the nectar of my flowers is a positive externality and a private good that accrues to the beekeeper whose bees feed on my flowers.

Thus, externalities can take many forms. For instance, external benefits from education: children gain from having educated parents; society benefits in so far as education reduces crime, social unrest, unemployment, and welfare costs; society benefits from an educational system that inculcates acceptable social values, improves communication, and strengthen democratic institutions, on the (external bads) side are many forms of pollution and other disamenities such as congestion and noise, etc.

Externalities in the Form of External Benefits:

Problems of social good-type arise not only in the budgetary context but also wherever private consumption or production activities generate external benefits. Suppose, for instance, that A derives benefits from being inoculated against polio but this also benefits others, since the number of potential carriers and hence the danger of infection, is reduced. Similarly, by getting educated, A not only derives personal benefits but also makes it possible for others to enjoy association with a more educated community. Since a large number of other consumers may be affected, the market does not work and a budgetary process is needed to secure preference revelation. But budgetary intervention, in this case, will not involve full budgetary provision; rather, it will take the form of subsidy to private purchases.

In the diagram given below, D_p represents the market demand schedule. It is obtained by the horizontal addition of demands for the private benefits which individuals derive from being inoculated or from having their houses painted or from having being educated. Now, let D_x be the supplementary schedule reflecting the evaluation by others for the external benefits generated by these activities. Example- the reduced risk of contagion or pleasure of an improved neighborhood or association with better citizens. The D_x schedule is obtained by the vertical addition of individual demand curves for such benefits.

Adding D_p and D_x vertically, D_s is obtained to reflect total benefits including both the D_p and D_x components. Given this situation, the private market will result in equilibrium at output OQ_p, since only the D_p schedule is backed by voluntary purchases. But this is inefficient since the optimum output is at Q_s where external or social benefits are also included.

In order to expand output from OQ_p to OQ_s the government should pay a subsidy per unit equal to FC, the difference between D_s and D_p at output OQ_s. Such a subsidy raises the effective demand confronting the supplier D^* and output will be extended to OQ_s. Consumers pay a net price of OR, with the subsidy contributing the difference RT. The total cost of the subsidy equals to RTCF and is paid for out of the budget, financed by taxes imposed on A and B.

All this would be simple enough, if D_x and the required level of subsidy were known, but this is usually not. Thus, the evaluation of the external benefits- and the determination of the proper rate of subsidy- poses problems of preference revelation similar to those which arise with social goods. This problem is resolved through the political process, i.e., the Budget.

The polar cases of social goods, examined earlier, may, thus, be extended to the cases involving goods in which internal benefits to the individual consumer are increasingly supplemented by external benefits. At the one extreme of the purely private good, the distance FC becomes zero, as D_s is the same as D_p and no subsidy is needed.

At the other extreme of the purely social good, D_s becomes equal to D_x and the subsidy pays the entire price, i.e., benefits are wholly external. The good becomes a pure social good and is entirely provided for through the budget.

In between, we have the cases of mixed goods, to be financed by a mix of private payments and subsidies. They may be treated as partial social goods.

The phenomenon of benefit externalities has its counterpart in external costs which are not internalized and not paid for by consumers or producers. As a result, costs are imposed on society which are not accounted for, and the activity in question tends to be overextended, while in the case of external benefits subsidy was called for, that of external cost calls for a penalty tax. This is the problem of how to deal with social “bads” such as pollution and environmental damage. A case of this type has been discussed below.

Externalities in the Form of External Costs or Bads:

Let us now consider a case of a commodity that generates external costs or bads. Suppose, the production of iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, has two components:

• the cost of the labor, machines, iron ore, coal, and other inputs directly required to produce the iron.
• The costs are borne by the members of the community in the form of air pollution damages.

However, the second component of cost is not taken into account by the market. Infact, private activities, whether in production or consumption frequently give rise to external costs which are not accounted for by the market. Hence, public (Government) intervention is needed to get this part of the cost to be internalized.

Efficiency and Equity Problems:

These external costs pose two problems:

In the first place, failure to account for external costs leads to an oversupply of products in question (i.e., here iron) and an undersupply of the benefits (i.e., clean air), which are reduced by pollution. This is the efficiency problem. If the damage cost of pollution were internalized, resource use would become more efficient. The price of iron would be higher, less iron would be produced and the air quality would be improved.

Second, the existence of pollution poses distributional or equity problems. Through, the loss of environmental quality, consumers of air are forced to subsidize consumers of iron, must, as they would if a tax were imposed on them (consumers of air) and transferred to the latter (i.e., consumers of iron). Are the consumers of iron entitled to impose this burden on the consumers of air or on the rest of the community or should they be made to pay compensation? Moreover, the incidence of pollution damage may fall with different weights upon low-income and high-income families, and this affects the distribution of real income. The same goes for the cost of pollution prevention and the net gains to be derived therefrom.

Efficient Solution:

It should, however, be noted that air is a public property. Moreover, it is a social good. The principle of exclusion does not apply. Hence, the market fails to take into account the external costs or the damages caused by air pollution. The benefit of these goods is shared by all those who are damaged by pollution.

Suppose that the production of iron involves an external cost, for example, smoke discharged into the air. The level of discharge increases with the output of X₁ as does the cost of damage. Then, in the following figure, AS is the firm’s supply schedule in producing iron, OC is the marginal damage cost (i.e., the loss of air quality, valued in rupees per additional unit of iron), and AS_t, is the summation of the two cost schedules i.e., AS + OC.

With demand schedule DD, competitive output in the absence of government equals OQ, since only private costs reflected in AS are allowed for, i.e. since the market takes into account only private costs reflected by AS schedule. However, the efficient output would equal OQ’ and make allowance for external costs as included in AS_t.

To put it differently, with DD as a demand schedule, efficient output equals OQ’, since it takes into account both internal and external costs (i.e., AS_t = AS + OC).

Different policy measures may be adopted to achieve efficient output OQ’. It may be achieved by a direct regulation forcing the firm to produce OQ’ output. Another possibility is to impose a tax per unit of output equal to AB, which brings about the same result. In both cases, output is reduced from OQ to OQ’ and the victims of pollution are spared pollution damage equal to Q’QEF.

An important point to note is that the efficient solution call for pollution to be eliminated. Pollution damage equal to OQ’F still remains. If pollution is cut back further, the gain from reduced pollution falls short of the loss from reduced consumption of X.

In geometrical terms, by reducing output from Q to Q’, the pollution damage equals GLMH, which exceeds the loss of consumer surplus from reduced consumption of iron or GLH. If the reduction in output is pushed beyond QQ’ the loss of surplus exceeds the reduction in pollution damage at the margin. Thus, output OQ’ is efficient out.