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Externalities & How They Affect You
So on today’s podcast episode we’re going to talk what I think is probably one of the most important and interesting economic concepts out there. It’s called externalities and once we understand the concept can really change our perspective.
Essentially, externalities attempts to explain how impacts caused by others affect us and the environment. The framework then offers solutions on what we can do about them.
The concept about externalities is fairly easy to understand. The formal definition is that economic transactions can have either positive or negative affects on a third party that are not accounted for in the price and transaction.
Translating these terms, economic transactions most commonly include the production or consumption of goods or services, and also investment choices. The third-party part refers to someone that is not part of the economic transaction but is impacted – including individuals, businesses, and the environment around us. These impacts can be negative if they cause harm or positive if they make a positive impact.
A key component of this theory is that the externalities are excluded from the price that is paid by the economic agents causing the effect – in other words, the costs paid by them do not reflect the true costs of their decisions. So if there’s a negative externality – as in that it harms the third-parties, the economic agent causing the impact is not paying the full price and those affected by the externality are paying the remainder. If there is a positive externality, it’s the reverse and the agent is overpaying.
Externalities are often considered by economists to be market failures – which is to say that there is a fundamental fault in a specific market and that some type of intervention is required to adjust the cost for what it really is.
Examples of Externalities
To give you an example, think of a factory that is constantly spewing out thick black pollution. This pollution is then breathed in by everyone around the factory leading to health complications, lower property values, and more. To make things even worse, this pollution enters the water systems and damages ecosystems.
In this situation, the producer is paying just to make and maintain their business but not paying for the environmental, health, and other damages that they are causing. In this case, they are not paying for the true cost of their business and this is at the expense of everyone around them and the environment.
In the age of global warming, this example is all to real and understanding this theory can help understand how these situations are looked at from an economics standpoint.
Another very real example of externalities right now is about wearing masks to prevent COVID-19. This is obviously a very heavily debated issue, but the majority of medical professionals currently state that masks can help reduce the spread of COVID-19 and research has shown that large scale usage of masks can reduce deaths and economic losses.
Under this belief, wearing a mask creates a positive externality while not wearing a mask can have a negative impact. This positive externality is then weighed against the negative impact of having to wear masks and the perceived reduction of one’s personal liberty.
What we see is that those that support wearing masks view the net outcome of this equation to be positive while those that refuse to wear masks view the outcome as negative. They may not consciously view the decision under this framework, but their underlying beliefs cause them to value one choice over the other.
Obviously the argument is not as simple as this, but the usage of the externality framework can help offer a perspective on the issue.
Overall, the externality model not only gives us a framework to understand these issues, it also offers solutions.
At the heart of the model is the price mismatch and this is what the solutions attempt to correct. So if there is a negative externality then increasing the cost to include the externality will reflect the true costs and a reduction in cost can be used if there is a positive externality. The idea is that this will act as an incentive to either dissuade or promote the activity. In some cases, other legislation or nudges can be used to cause a change.
Continuing the example about pollution, a carbon tax is often touted by economists as the preferred solution. What happens here is that a price is assigned to the negative externality caused by the pollution which then needs to be paid by the one causing the pollution – typically either a producer or consumer. If the cost is large enough then this will affect that agent’s decisions and help create demand for other solutions. So a motorist confronted with increased fuel prices may decide to buy a more fuel efficient vehicle instead of the gas guzzler that they had before.
On the flip side, choices that have positive environmental impacts would receive subsidies to make it cheaper to do the beneficial activity. A popular example here is offering a payment to those that buy electric vehicles.
These price changes are really meant to put the costs of the choices to what they really are and are fixing a market failure.
Governments may also use behaviour economic theory like nudges to promote certain activity. These come in many forms, but are essentially cues that can help push a person to make certain choices. A famous example is causing people to opt out of retirement plans instead of opting in. This has lead to large upticks in usage and reduces the issues from underfunded retirements.
Overall, externalities are super interesting and can be applied to our everyday life. Even your personal finance journey can have positive externalities. If you share the information that you gained with people around you then you make a positive impact and additional value.