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What is an externality?

You might hear an economist say that the key to a sustainable and equitable future lies in addressing externalities. This term ‘externality’ pops up frequently in the world of economics and policy, and seems quite important. So what is it? What is an externality and why should you care about it?



Externality and Arthur Cecil Pigou: A love story

About a century ago, a British economist named Arthur Pigou published The Economics of Welfare, in which the concept of cost-price discrepancy was first brought into mainstream academia. Pigou noted that certain products were being sold for less than they cost society to make, and that this discrepancy was leading to issues. Pigou’s career was focused on actual costs and prices and how they influenced the market and human welfare. He was one of the first economists to lay out a framework for thinking about externalities. The cost-price framework has a few basic elements and can be thought of as follows.


Costs and Prices

‘Cost-price discrepancy’ is a fancy way of saying that there is a difference between how much a product costs to make, and how much it is sold for. Before we go further into this discrepancy, it's important to define ‘cost’ and ‘price.’ The ‘cost of a product’ covers just about every way that the product is a cost to society. We can approach the ‘cost’ by using two distinct components: private cost and social cost.


The private cost of a product is how much resources (time, money, labor, and so on) it requires for the manufacturer (or provider) to make. For example, if you are a cookie maker, your private costs will be the flour, sugar, baking powder and other ingredients, along with the time and electricity it takes you to bake the cookies. The private cost of a product is what most people think of when they think of costs.


The social cost is the cost of the product to society. This is arguably just as important as private cost. You can think of the social cost as how the product fits into the larger societal picture. For example, the pollution cars put out brings harm to both people and places (it is bad for our lungs and acid rain has destroyed many forests and ancient marble statues). Note how this cost is placed on society and not the owner or manufacturer. The damage to forests and statues impacts everyone, whether or not they own a car. This is the social cost of cars.


The final piece to this puzzle is the price of the product in the market, which is simply how much someone pays the manufacturer. The question du jour is then: does the price accurately reflect the total cost (private and social burden) of the product? In the United States, the answer to this question is often, unfortunately, no. The market in the U.S. does a remarkable job at reflecting private costs in prices. Think: why would you sell a product for less than it costs to make? You’d be out of business in no time! However, prices in the U.S. rarely reflect social costs. For example, when I bought my car, I did not pay for the damage that the pollution from me driving the car would cause. Alas, we have arrived at the concept of externality.

Externality

When a product is sold for less than ALL of its costs, the result is a negative externality. This means that there is a net harm that is occurring in society, especially on those who had nothing to do with the transaction. A clear example of this is in plastic bags. Most stores give them away for free (or a very low price), when in actuality they cost a lot. Plastic bags cause a significant amount of ecosystem and financial damage every year, which everyone pays for, whether they use a thousand plastic bags or none. Yet, despite this, you can still walk into just about any store in West Chester and ask for a plastic bag and you will be given one without a second thought. What’s going on here? This is because the majority of the cost of a plastic bag lies in its social cost, and not its private cost. Plastic bags are cheap and easy to manufacture (private cost), but the damage they cause on natural environments is difficult to quantify and impacts everyone (social cost). The way we can think of the total and actual burden of a product is both the social and private costs added together. Thus, even though the plastic bag has a low private cost, its total cost is high.


In the United States, the private cost is usually the only cost that is reflected in the price, as we have no concrete system for addressing the social cost. As a result, you can get plastic bags at your local grocery store for next to nothing, despite the fact that they cost society a lot in environmental and financial damage. The plastic bag is a clear example of a product that has a negative externality associated with it, but it is far from the only example.

Fossil Fuels and Negative Externality

Perhaps the most common products that have associated negative externalities are those which rely on fossil fuels— particularly those which involve combustion. Cars, planes, and home furnaces are all examples of products that have negative externalities. Each time that I drive to work, or turn on my home furnace (I have an old, fuel oil system), I am causing pollution that will harm the environment and those around me. Yet, every time I turn on my car or furnace, no one presents me with a bill for the damages. It is therefore easy for me to act as if they do not exist.


It is, however, very important to remember that they do exist, and this unseen nature is exactly how the externalities associated with fossil fuels work. Imagine if every time I drove my car I was presented with a bill for something like the fraction of sea level rise that my emissions caused that month. I might act a little differently.


While, this is not the world we live in— a bill for my externalities has yet to arrive on my doorstep— it may not be far off. As scientists and economists more fully understand how our actions impact our environment, they are warning that we must start accounting for the full costs of our actions. That means knowing the full picture of our actions, and how they impact those around us, not just their impacts on our own lives. We live in a world of costs and prices. As a society who portrays itself as striving towards equity and sustainability, it's time we start acting like it.

In Brief (sort of)

  1. The total cost of a product is best portrayed through two categories: private and social costs. a. Private costs are how much it costs the producer to make the product. Think inputs, labor, taxes, the types of costs that are easily identified and clear. b. Social costs are burdens that the product places on society as a whole, and a burden that any one person does not solely bear. These are much more difficult to identify, and are difficult to mitigate because their impacts are spread out over everyone. An example is personal vehicles: the pollution they emit impacts everyone (roughly) equally, in the damage it causes. Since it is not felt only by the driver of the car, drivers are not incentivized to change habits. c. Prices are simply how much a consumer pays for a product.

  2. Cost-price discrepancy is when the price of a product does not reflect the total cost of the product.

  3. A negative externality occurs when a product is sold for less than its cost to society. The excess cost is unaccounted for in the purchase price and thus a net-detriment occurs. This harm impacts the lives of everyone, some who had nothing to do with the original product or transaction. For example, the pollution of my car hurts the environment and health of people in West Chester who do not even own cars.

Article written by Eric West, Undergraduate at Cornell University

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