What Are Externalities?

This post is meant to give you a basic understanding of what externalities are, some examples of them, and an introduction on why they matter and need correction. Here we are particularly focused on negative externalities - since these are both more common and from a policy perspective, far more important.

While it is not a prerequisite - information from the following article will be useful to fully grasp the concepts here: Paradox of Thrift, Fallacy of Composition, Austerity, and Second-Order Thinking

When someone makes a purchase, or a trade - it seems to be clear, at first, what the costs are and who is getting what. Entity A gets X and Entity Y gets B. Simple enough, right?

Intuitively - it is clear to see these direct costs to each party:

The Seller

• Cost of producing that good (including labor, materials, marketing, etc).

The Buyer

• Cost is the money they spent to purchase the good or service.

Enter, externalities.

The above costs are the only ones taken into account in the private transaction - however there are other costs associated with the transaction - almost all of them are costs to society as a whole or other groups of individuals.

Examples

Some examples of negative externalities.

1. Alcohol sales

   The cost of a beer, for example, is relatively straightforward. You pay some small amount of $ for a beer, and they give you the beer.

   However, there are a few second order effects of selling and consumption of alcohol on society:

   • Public Disorder
     • Bars can become rowdy, fights occur, public places become overly noisy, people commit more crime when drunk in general, etc.
     • Our tax money must be used to address these issues - such as police having to respond to a fight in a bar.
   • Health Costs
     • There are many health implications of drinking alcohol that cost a lot to treat.
     • The more money spent on this, the higher insurance rates go for others. Additionally, the more effort spent on these issues - the less healthcare workers can solve other health issues or do research.
   • Drunk Driving Accidents
     • Drunk driving kills, on average, 11,000 people a year (average of 2013 - 2022). This is one person every 39 minutes. (Source)
     • Not to mention, all of the costs for treatment of non-fatal crashes.
   • Productivity Loss
     • The overall economy loses productivity because of alcohol for a few reasons:
       • Alcohol related deaths reduce the amount of people in the labor force who can produce goods and services, as do major injuries tied to alcohol.
       • Hangovers and missing work or reduced productivity at work, as well.
       • Excessive drinking, in 2010 (most recent data available) cost the economy around $249 billion dollars. (Source)

2. Traffic Congestion

   Consider an area where the traffic is immense, during specific times or otherwise. Traffic jams are common in this situation, and people tend to be stuck in these jams.

   • Productivity Loss
     • If people are late to work and miss some work - they are less productive by definition.
   • Fuel Consumption Rises
     • Increasing pollution (not just climate change concerns, but burning fuel gives people diseases due to airborne pollutant)
       • These include high rates of lung cancer, asthma and respiratory issues, heart diseases, and neurological disorders. These take a huge toll on people and the economy.
     • There is more demand for fuel - and therefore gas prices rise.
   • More Accidents
     • Stop and go traffic increases the rates of accidents especially rear end collisions.
     • Tax payers fund emergency services, insurance premiums rise, and the traffic jams worsen when there are accidents.

3. Social Media Applications

   Social media companies design their platforms to maximize user engagement through notifications, algorithms, and addictive content loops. Billions of people spend large portions of their lives scrolling on social media - users get social media and the companies get money from ads and the user’s data.

   • Mental Health Issues
     • Increased anxiety, depression, and social comparison. The costs of therapy, medication, and reduced productivity are borne by individuals, employers, and public healthcare systems.
     • Suicides due to social media are common.
   • Spread of Misinformation
     • False or harmful information spreads rapidly, affecting public discourse and leading to societal costs like political polarization and public confusion.
     • Misinformation has caused many deaths, as well.
   • Productivity Loss
     • Excessive screen time affects workplace performance, increasing indirect costs for businesses and government.

You can see, there are a lot of very very bad second order effects to lots of types of commerce. Some of these have some taxation attached to help offset the societal issues they cause - but often it’s too low - and most of these have nothing to offset them at all.

There are so many examples of negative externalities, but I won’t go on and on.

Why Is This Important?

In many, many cases - corporations make enormous profits while the individuals in society pay the costs in both direct and indirect ways - externalities. All of us are paying extraordinarily, while millionaires and billionaires laugh at us on their pile of cash.

Is this theft?

Duh!