Externalities:
A Simple Matter of Pure Economics
M. P. Ross 04-29-2022
Sitting through hours of course lectures, it must be the rare undergraduate who has not at least once wondered when they would ever use a particular bit of information. For those who took Principles of Economics, the microeconomics semester of the full course, here is your answer. About two-thirds down the course syllabus will be the lecture on externalities, a cost or benefit to a third party, that is someone other than the buyer or seller of a good. In the textbook, the accompanying graph would show a line representing the cost of goods, with another line above and the space between them representing the social costs. Pretty exciting stuff.
Social costs are not mere abstractions, particularly to those who must pay for them in actual dollars every bit as real as those spent by sellers for raw materials and production and buyers for retail goods. Ignoring externalities, treating them as somehow adjunct to the mainstream of economic activity, doesn’t make them go away. It would be useful to introduce the concept of economy as ecosystem, and a global one at that, in which actions feed back into the system in ways that impact it as a whole, even as individual buyers and sellers focus on the specific costs and benefits that affect them. Externalities need to be formally recognized, made part of the economic discussion of which they are an integral part, in some fashion, even if not directly included in the cost of goods. First, let’s bring this idea down to ground level.
The purchase, sale, or rental of one’s home is a common economic activity to which most Americans can relate. Your next door neighbors have sold their home. The buyers are having the old home torn down and building a new house, turning your residential quiet into a busy construction zone for at least a year. The buyer doesn’t want it to take any longer than it has to; they’re paying two mortgages, their new home remains an extra expense until they can move in and sell their current one, and likewise every extra day costs the contractor more, eating away at the projected profit. In the meantime, all this activity next door is creating headaches for you. Your house suffers misc. and sundry minor damages: the driveway splattered with paint, dirt and debris get in your pool, asphalt fumes aggravate your child’s asthma, all demanding your time and money. These are not just inconveniences, but real costs that impact your budget. The seller realized the proceeds of the sale, the buyer gets to enjoy their new home, and the contractor the profits from the work. You, however, are burdened with clean up and healthcare costs unrelated to any actions on your part. To economists, these costs represent negative externalities. You may have no remedy other than suing, if you can afford to do so. Good luck getting fully compensated for the whole ordeal.
On the other hand, it turns out to be a positive experience. The contractor is conscientious, keeps noise and dirt to a minimum, never blocks your driveway, plus as a goodwill gesture scrap wood is cut to short lengths and stacked in your woodpile. An entire year’s firewood, for free, without having to lift a finger. That benefit is a positive externality.
People do what they do. Externalities, however much damage and costs they create, are more the result of an understandable focus on completing a task, delivering the greatest benefit to the producer and end user, not the willful intent to do harm. However likewise understandable the desire to paint the offending source of externalities in negative terms, (and make no mistake, application of the time-honored test that if it walks like a duck justifiably suggests the commission of RICO-worthy felonies in many examples, such as those related to the 2008 financial crisis), neither name calling nor after the fact indictments gets us very far on the way to a satisfactory solution.
Quantify, don’t vilify; or to re-appropriate a phrase, it’s the economics, stupid. Recognizing and accounting for externalities, in the general sense of these terms, is a simple matter of pure economics. These costs and benefits are actual, and asking business and society to deal with them is not some game of gotcha with the intent to slap on penalties. The fact that externalities do not have a regular place on an accounting income statement, except perhaps under costs of litigation or environmental remediation, is an omission out of convention, and their inclusion common sense. Remedy requires a bit of a rethink.
President Obama’s “you didn’t build that” comment, both perhaps misstated and taken out of context, makes an important and too often unappreciated point that it is our society, the whole of our political and economic system, which makes personal success possible. The fantasy of individual accomplishment, (one we all might be forgiven for indulging in at one time or another), seems to slide past a few crucial considerations, chief among them the buyers our star seller needs to complete transactions. The fantasy further neglects to note that all those buyers are not merely fully independent individuals, but participants in a complex interplay of activity. A fair and stable social, political, and economic environment, make individual success, both great and small, not only possible, but sustainable. The economy as ecosystem.
Technology created for the military, the space program, and other federal projects, benefits business and individuals: Tang, GPS, the Internet, and the Interstate Highway System. It might be a stretch to call taxpayer funded goods, which ultimately benefit taxpayers, positive externalities, but it expresses a larger point relating to concerns about federal government action and spending as impositions on the rights of the individual (and the corporation as individual). Add to this a whole range of public goods, such as infrastructure generally and education, which benefit not just the individual, but society through the actions of that individual directly due to that individual’s use of those goods. “You didn’t build that.” You didn’t build that alone. Failure to recognize this is to ignore the body of political thought going back at least as far as Plato and Aristotle.
Contemplate this scene: An Arleigh Burke class guided missile destroyer framed by a large commercial port sprawling across the entire background. That is a positive externality. Global trade made possible by American taxpayer dollars, the U.S. Navy helping to keep the world’s oceans safe for shipping traffic. Again, a benefit paid for by all taxpayers, broadly enjoyed in the form of jobs and consumer goods, less broadly as shareholder value, and much more narrowly in outsized CEO compensation. What would corporations do without this benefit? Destroyers don’t come cheap.
Externalities, when discussed at all, most commonly refer to the negative variety. Any human activity can cause externalities: pollution from industry; resource extraction, such as mining, or oil and gas production; business activity in finance or real estate; government regulation, either too much or too little.
Trump campaigned on building a border wall between the United States and Mexico, and later suggested paying for it with an import tax: this brings us back to the economy as ecosystem, where actions targeted on one part of the economy can create unsought disruptions in other areas. An import tax, depending how applied, would raise the wholesale price of goods, most likely raising the retail price of the item, thus a higher cost to the consumer. For goods with an inelastic price, manufactures would have to absorb the extra cost, lowering their profit margin. The impetus for the import tax was to pay for the construction of the wall, sold as a national security need. Based on other policy statements from his administration, it could be inferred that the new tax, raising the cost of imported goods, would stimulate demand for domestic goods which can be sold competitively at the now higher price of the imported, hopefully creating new jobs at higher wages. However, a complicated sequence of factors would have to fall into place for the benefit of those higher wages in one sector of the economy to have a positive effect on the economy as a whole. First, higher wages as a cost of producing those goods cannot raise the retail price above that of the imported, unless the market places a premium on domestic goods, which it has thus far not shown a willingness to do. Next, it is a big assumption that the net effect of an increase in the price of imported goods would generally raise wages across enough of the economy to keep the cost of goods within the budget of the average American. Given the greater job loss to new technology rather than cheap imports, higher wages in this example are unlikely be sufficient to offset the greater cost of goods to consumers, who would have bought themselves a 1000-2000 mile border wall.
The cost of regulation to businesses and the economy vs. the cost of externalities. Implicit in regulation is the concept of identifying conduct that results in externalities, deterring it through sanctions, supported by the legally established basis for remedy to injured parties. Regulations tend to become a kind of political strawman, another of the polar rally points where kind and quality are stripped from degree and scope. Valid arguments are found on both sides. It should not be thought treason to the cause to either admit that regulations should not hinder the economy or society with layers of stifling bureaucracy or that for want of sensible well enforced regulation those seeking redress best hope is a Pyrrhic victory through lengthy and costly litigation.
It was indeed troubling when Trump expressed a general opposition to regulation, most strongly communicated through his cabinet level appointments of officials seemingly opposed to the very purpose of their departments. Regulatory review and reform make sense, and should be a part of an effectively functioning government. Small government advocates make much of reducing the role of the federal government, allowing it a place notably in national defense, narrowly construed as external or foreign threat. But what of protections for the average citizen against the power and influence of domestic warlords of the commercial kind? Absent the rule of law, laid out as sensible regulation, they would effectively be left defenseless, financially outgunned, to either go it alone or band together in class action lawsuit. For all the talk of American exceptionalism, however true or not, the United States is a modern, advanced nation; it would turn history upside down for us to allow it to revert to some kind of Hobbesian state of nature where it is everyone for themselves and those with the most to spend prevail.
Americans in our daily lives feel the impact of externalities. We pay the costs they levy with real dollars that could otherwise go to housing, healthcare, and education. True, as a society, we benefit generally from a stable social situation, stable currency and interest rate, and a mostly fair and transparent government that has consistently delivered orderly transfers of power at all levels from small town mayors to the president. But the system as a whole is supported by taxes which weigh most heavily on those with the fewest financial resources. Setting aside income tax, low income earners pay a disproportionately high percentage of their incomes on sales and use taxes which fund roads and schools, and all the functions of local government, even as they tend to live in areas that suffer higher rates of pollution from sources whose profits they do not share.
A simple matter of pure economics, the auditors should point out. Right here, as plain as day. It would be sloppy accounting, willful ignorance, not to mention a breach of professional ethnics, to omit calling them to your attention.
Externalities formally introduced into the debate, clearly identified, quantified and translated into dollars, and dealt with as established costs and benefits, would provide at least some relief to the kind of finger pointing and name calling, cries of interest group politics, and assertions of entitlement that attempt to pass for serious discussion. Besides, no one likes to be taken for a sucker, shouldering the costs while someone else picks up the profits. It is a lot harder to ignore a line on an income statement reviewed by auditors than an isolated claim of injury lost to the customer service voicemail.