Introduction to Externalities

What are Externalities and their Social Impact? 

Understanding externalities are critical to foster measurable policies within the social impact parlance. Externalities are an integral part of our life, but difficult to comprehend their impact on wellbeing within the socio-economic terminology. Externalities lead to market failures that need to be addressed by government interventions when bargaining fails to materialize between the parties involved. Market Failures occur when the invisible hand cannot efficiently allocate the recourses optimally; this suboptimal efficiency is due to the externalities involved in the goods or services transacted between the consumers and producers. The consumer and producer surplus are maximum at market equilibrium, so any deviation from market equilibrium leads to suboptimal output.

Externalities are Third-Party Effects: 

Third-party costs are associated with entities not involved in producers’ and consumers’ transactions. 

These costs or benefits are hidden or not accounted for by the producers of goods and categorized as indirect costs. Externalities arise due to a lack of property rights leading to the tragedy of commons.

Figure: The middle Road | Academic Reference Economics Lipsey and Crystal

* IMF terms many of these externalities as technical externalities; that is, the indirect effects impact the consumption and production opportunities of others, but the price of the product does not take those externalities into account.

Understanding Externalities | The middle Road | Online Courses  

Externalities play a paramount role within our Society. Climate change and passive smoking are excellent examples of negative externalities. The harmful emissions from factories release carbon dioxide and methane gas that cause global warming. 

WHO studies estimate that more than 8 million people die every year due to Tobacco use?

About 1.2 million deaths are of non-smokers (passive smokers) exposed to tobacco smoke. The costs associated with these externalities are colossal. Negative externality doesn’t measure the cost of healthcare to the society example, medical, emotional costs, etc. Negative externalities add external costs to the Society that don’t reflect the cost of goods or services consumed. Social costs are the sum of private costs and costs related to Society. Negative externalities increase social costs for Society. On the other hand, positive externalities increase social benefits to Society.

The figure showcases the effect of negative externality on optimal equilibrium. The marginal external cost i.e., the iterative external cost due to the addition of a unit of good or service, shifts the equilibrium to the left to point b from a. The hidden costs due to negative externalities reduce the number of goods taking the new optimal quantity to q*.

• Social Costs are Sum of Private Costs and Costs related to the Society
• Social Benefits are Sum of Private Benefits and Benefits associated to the Society

Externalities are due to a lack of property rights. Eradicating externalities remains the focal point of informed policymaking. Market Failure occurs when free markets fail to achieve an efficient and optimal allocation of resources and goods. Take the example of perfect competition, a commoditized market with no critical differentiation between products. The price and quantity of the product are driven by the equilibrium of demand and supply of the product or service in the marketplace. Firms want to maximize profit, i.e., sell at marginal cost (MC) because marginal cost equals marginal revenue. I am extrapolating the concept to welfare jargon -marginal private cost = marginal private benefit for a welfare equilibrium. The divergence between private costs and benefits and social costs and benefits cause Externalities. A positive externality occurs when marginal social benefits exceed marginal social costs due to the inability of the demand curve to factor in all the benefits (demand-side market failure). The marginal social cost is more than the marginal social benefit for negative externalities (supply-side market failure). In the above example of negative externality, the price p and quantity q are the equilibrium quantity and price. However, this equilibrium quantity ignores the marginal external cost associated with the product or service. Negative externalities add up external costs shifts the marginal cost curve to the left, reducing the quantity to a new equilibrium point q*. Refer to the education video inset. At this unique point, the amount supplied reduces, and the price of the quantity delivered increases. The reduction implies an equivalent tax per unit of product or service.

# Policy Initiatives: Taxing negative externalities; promoting and subsidizing positive externalities

Arthur Cecil Pigou, a brilliant English economist at the University of Cambridge, known for his work in welfare economics, was the first to suggest taxation to curtail negative externalities. An excellent example of taxing negative externalities is an exercise tax on packs of cigarettes, a policy used to reduce consumption of smoking due to wellbeing and costs related to both active and passive smoking. Exercise tax affects the supply curve with a fraction of the taxes passed on to the customer.

Refer to the video below to understand how negative externalities can be taxed. The below educational video looks at a simple mathematical equation to calculate tax implications by introducing an exercise tax on the sale of alcohol. The exercise tax is on the per-unit sale of alcohol bottles.

Video : The middle Road 

Government interventions are necessary to address these market failures. Government can impose exercise taxes, implement bans on cars within specific areas within a city, increase green mobility by promoting electric vehicles, offering green tax rebates to electric vehicles, etc. Singapore is one of the few countries that has successfully built and upgraded world-class infrastructure for its citizens. Singapore’s government taxes the purchase of new commercial vehicles to limit the number of vehicles on the road. The policy aims to reduce traffic congestion associated with pollution and promote public transport. Pontevedra, a scenic Spanish city, has used no car policy at the city center to reduce pollution and traffic congestion.

Vaccines are an excellent example of a public good (if free for everyone) that leads to underproduction due to its positive externalities. 

As seen, positive externalities lead to a demand-side failure with marginal benefit higher than marginal cost. Vaccines help stop the transmissibility of communicable diseases to a third party (nonexcludable and non-rivalrous), keeping time constant, an avoidance of vaccines, significantly for COVID-19, leads to negative externalities. Assume that COVID-19 vaccines are freely available to people free of cost and have a high probability of fighting the novel coronavirus; avoiding vaccination increases the risk of transmissibility of the novel coronavirus to other, especially unvaccinated people. Due to its high external costs that could lead to personal agony, medical, and other expenses, should the government tax people who deliberately avoid vaccination or give incentives for getting vaccinated. Does this policy infringe on people’s liberty, especially when eschewing vaccines can put others in danger, including mortal threat? How will you calculate the marginal external tax as a policy Top Gun? It’s an excellent point to ponder.

Refer to the applied economics lesson on excise tax on The middle Road – Applied Learning