The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

External Effects

We have always known that heedless self-interest was bad morals; we know now that it is bad economics.

                                                            ..... Franklin D. Roosevelt

Competitive markets can fail to produce efficient results when external or spillover effects occur.  The intuition is simple.  Suppose Alice considers only her own best interest in choosing what to produce and buy.  She rationally will choose to produce or buy only as long as the MB she gets covers her MC.  From her private perspective, this is an efficient result. 

However, suppose that Alice is not the only one affected by her decisions.  Suppose some of the benefits or costs of her choices spillover to other, external parties.  If so, what is best from Alice’s private perspective is not necessarily best from the group’s perspective. 

External costs

For example, suppose Alice will receive a $10 benefit from producing some product or action and estimates her MC at $7.  From her perspective, production makes sense; it will create $3 of new surplus value for her.  But suppose her production will cause $5 of damage to others.  The MC to Alice may only be $7, but the MC to overall society is now $12 [$7 to Alice and $5 to others].  Since the MC to society [$12] exceeds the MB Alice will receive [$10], production is inefficient.  The $3 private surplus Alice can create will be more than offset by the $5 cost imposed upon others.  Even though Alice has a private incentive to produce, society will be worse off if she does.

Can we trust Alice to sacrifice her $3 private surplus to avoid damaging others?  Perhaps.  There certainly are many examples of individual who sacrifice personal gain for the good of the group.  But we should not hold our breath.  Self-sacrificial behavior does occur, but it rarely is the norm.  More often than not the Alice’s of this world act to maximize net personal benefit rather than net social benefit.  If so, Alice will overproduce the product or action in question.

Can you think of real world examples?  How about pollution or litter?  When we dump refuse into a river or throw litter out of the car window we are trying to minimize inconvenience to ourselves at the expense of others.  When we turn up the volume on our music to the chagrin of those around us, we are creating external costs.  When we rob, rape and pillage, we create external costs for others.  In each of these cases, allowing individuals the “freedom” to act as they wish damages others.

Do you see the point?  Allowing individuals the freedom to allocate resources in any way they want works quite well if those individuals are the only ones affected.  Individual freedom is efficient.  But when the choices of one individual negatively impact others, private self-interest can conflict with social interest and individual freedom of choice  no longer is a good thing.  Hmmm.  Maybe that’s why society has laws.  After all, laws do restrict our personal freedoms.  They take away our freedoms to pollute, to play our music too loudly, and to rob, rape and pillage.  If written correctly such laws can increase social efficiency.

No doubt you are eager to see a graphical representation of this concept.  Let’s try it.  When external costs are present, the MC to society exceeds the MC to the private decision-makers.  For example, if the per-unit production of a good or action creates a $25 external cost, then the MC to society is $25 higher than the MC to the individual producers.

Remember that the supply curve for competitive firms is nothing more than the MC curve faced by the producers.  As before, the competitive market equilibrium occurs at the point where supply [MC to producers] intersects demand [MB].  Output Q₀ in the graph below is the equilibrium.  But for allocative efficiency we should produce only as long as MB covers the MC to society.  In the graph below, allocative efficiency occurs at output Q1.  The competitive equilibrium is not efficient; it creates an inefficiently large output of the good or action.

When actions create external costs, allowing free individual choice is not efficient.  Government programs designed to decrease output from Q₀ to Q₁ make good economic sense.

Property rights

External cost and pollution issues are most likely to arise when property rights are not clearly defined.  For example, no one “owns” the air or the oceans.  As a result, no one has the incentive to care for them efficiently. If I owned the air, I would be more reluctant to pollute.  After all, the pollution would damage my air and lower its value.  Air pollution would no longer create an external cost; it would create an internal cost to me.   Similarly, vandalism occurs in college residence halls around the country.  The vandalism typically occurs in “common” areas such as bathrooms, hallways, elevators, and study lounges.  We simply do not care for commonly owned resources as effectively as we care for our own private property.  This tendency to misuse such resources often is termed the tragedy of the commons.

External benefits

            Some spillovers create benefits rather than costs for others.  If Alice plants flowers she will have a more beautiful view to admire, and so will her neighbors.  If she installs a streetlight by the road she will be able to better navigate the neighborhood at night, and so will her neighbors. 

Will she plant efficient quantities of flowers and install efficient quantities of streetlights?  Not necessarily.  If Alice acts only out of self-interest and ignores the benefits that spill over to her neighbors, she will perceive flowers and streetlights to be less valuable than they really are and be less willing to create them.

For example, suppose the flowers create a MB of $10 to Alice and $5 to her neighbors.  Suppose also that there is a $12 MC to Alice in planting and caring for the flowers.  Will she plant?  The $15 MB to society [$10 to Alice plus $5 to her neighbors] more than covers her $12 MC.  Planting is allocatively efficient for society.  But planting is not allocatively efficient to Alice.  Her $12 MC exceeds her $10 MB.  Planting may create $5 of net benefit to her neighbors, but it creates a $2 net loss to Alice.  Will she sacrifice for the good of the neighborhood?  Probably not.

In this case of external benefits Alice has a tendency to underproduce the good or action in question.  Inefficiently small quantities are likely to be produced.   Check out the next graph.

When external benefits are present, the MB to society exceeds the MB to individual buyers.  Q₀ is the free-market equilibrium output, but is not allocatively efficient.  Because the units from Q₀ to Q₁ all generate MB to society in excess of MC, Q₁ is the allocatively efficient output.  Because the units from Q₀ to Q₁ are not produced, society loses the surplus value they would have created.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.         Explain the concept of external costs, give examples, and explain why markets will tend to produce more than the efficient amounts of goods that create such effects.  Illustrate this inefficiency with numerical examples and with an appropriate graph.        

2.         Describe and explain the tragedy of the commons; apply it and the concept of undefined property rights to the problem of pollution.

3.         Explain the concept of external benefits, give an example, and explain why markets will tend to produce less than the efficient amounts of goods that have such effects. Illustrate this inefficiency with numerical examples and with an appropriate graph.        

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