Understanding externalities are critical to foster measurable policies within the social impact parlance. Externalities are an integral part of our life, but it’s not easy to comprehend how externalities impact wellbeing within the socio-economic parlance. 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. At market equilibrium both the consumer and producer surplus are maximum, so any deviation from market equilibrium leads to suboptimal output.
What are Externalities and their Social Impact?
Externalities are Third-party effects: Costs associated with entities not involved in the transaction between producers and consumers. 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.
* IMF terms many of these externalities as technical externalities; that is, the indirect effects have an impact on the consumption and production opportunities of others, but the price of the product does not take those externalities into account
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 every year more than 8 million people die 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 in 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 by increasing costs related to society. On the other hand, positive externalities increase social benefits to the society.
Figure: The middle Road | Academic Reference Economics Lipsey and Crystal
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 related to the Society
Externalities are observed due to a lack of property rights. Eradicating externalities remains the focal point of judicious 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. The firms want to maximize profit i.e. the firms sell at marginal cost (MC) because marginal cost is equal to marginal revenue.
Extrapolating the concept to welfare parlance, for a welfare equilibrium, marginal private cost = marginal private benefit. 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 inability of the demand curve to factor in all the benefits (demand side market failure). For negative externalities (supply side market failure), the marginal social cost is more than marginal social benefit.
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 new point, the quantity supplied reduces, and the price at which the quantity is supplied 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 educational services under Online Learning at The middle Road.
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.
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 promotes world-class infrastructure for its citizens. Singapore government taxes the purchase of new commercial vehicles to limit the number of vehicles on road. The policy aims to reduce traffic congestion, associated pollution and promote the use of 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 related positive externalities. As seen positive externalities lead to a demand-side failure with marginal benefit higher than marginal cost. Since vaccines help in stopping the transmissibility of communicable diseases to a third party (nonexcludable and non-rivalrous) keeping time constant, an avoidance of vaccines especially 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, an avoidance of vaccination increases the risk of transmissibility of the novel coronavirus to other people, especially unvaccinated people. Due to its high external costs that could lead to personal agony, medical, and other costs, 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 danger.
As a policy Top Gun, how will you calculate the marginal external tax ? It’s an excellent point to ponder.
# Mangrove Action Project
The Mangrove Action Reforestation Project in a coastal village in Thailand is one such intervention. To stop the removal of Mangroves by people for shrimp farming, researchers exemplified the use of these trees among inhabitants showcasing the importance of beehives for a sustainable livelihood. Mangroves attract bees and through informed training sessions, the Mangrove project educated inhabitants to nurture beehives for honey. This improved skill set led to an alternative source of livelihood hitherto unknown to the coastal community. With more than 300 beehives in the village, the revenue from the sale of honey and honey-based products from the beehives increases income level, strengthens community links leading to more learning concentric skillsets example marketing of the products, etc. About 10 percent of the income from the sale of honey is invested into a community conservation fund leading to a halo effect (a positive externality) in attracting nearby communities from villages to learn new talent and forge alliances for best practices for conserving nature. Positive externalities must be promoted and subsidized for generating social wellbeing in society.
In the figure, the social marginal benefit is the additional benefit you receive when you consume an iterative or additional unit of goods or services. The graph can also be depicted using the social benefit. The demand curve is the additional benefit that consumers are willing to pay while the supply curve can be termed as the marginal cost or private cost. Due to many positive externalities, the optimum level of the social marginal benefit exceeds the private benefit by the marginal external social benefit. The private benefit curve does not highlight the true benefit of the intervention and the optimal value is the new social optimal equilibrium. The marginal external benefit is the subsidy (p-p*) per unit herein. Goods or services with positive externalities need to be subsided.
Fig: The middle Road | In the above figure, the Total demand curve shifts to the left listing the increase in the total benefit to the society. The optimal level B IS higher than the equilibrium A. Total Social Benefit is sium of marginal external social benefit and private benefit. This increase in the marginal external benefit is the subsidy (p-p*) per unit. Here p* is the price at the equilibrium, the optimal price is p.
One way to remove externalities is to use a bargaining process between the parties involved. Ronald Coarse proposed the concept that two parties will bargain with each other to remove externalities through an economic trade-off provided transaction costs are low. In this example, the coastal inhabitants need to be persuaded to stop cutting down mangroves by complementing them with a better economic trade-off. The profits from Shrimp farming drive biodegradation of Mangrove forests, market actors need to offer a better alternative to inhabitants to curtail felling mangroves, in this case, its economic trade-off from honey and honey-based products. The other party could be climate action activists and biodiversity champions example nonprofits, foundations, corporate social responsibility arm of major corporations, or social entrepreneurs and government. The rise in global awareness and activism for nature conservation in recent years is leading entities to address externalities for the better of humanity. In Mangrove Action Project, the economic and positive externalities by conserving and protecting the trees (higher income, community building, better sustainable agricultural practices, ancillary skill sets of marketing, decrease in carbon footprint, etc.) exceed the economic profits derived from shrimp farming over a long time. Mangrove Action Project, implemented by a UK based nonprofit, is an excellent example of using Nature-Based Solution to turn around a negative externality (healthcare costs due to increase in carbon footprint) through a set of interventions that lead to positive externalities on the back of a sustainable alternative livelihood for communities involved. MAP has implemented its workshops in 16 countries with stellar results. In Sri Lanka, MAP along with Sewelanka Foundation has implemented two workshops in Sri Lanka with measured success.
In many cases, it’s not possible to fully comprehend the external social benefit of a particular action. Ronaldo’s recent endorsement of water via a viz carbonate drink at the recent Euro championship led to a holistic lifestyle statement on health and nutrition for the better of millions of his fans. The social impact and economic value of Ronaldo’s gesture, immeasurable.
Refer to the upcoming Microeconomics tutorial series on The middle Road under Online Learning section.