Home > Externalities, Micro concepts > The missing market for externalities

The missing market for externalities

October 14, 2011

Externalities are the non-market impacts of an activity which are not borne by
those who generate them. They are the direct effects of the actions of a person or firm on the welfare of someone else in a way that is not transmitted by the market price system.

Lets say you enjoy the music of a small local band, and usually you can watch them perform live at a local venue for £4. Then suddenly they become ‘big’ and a load of new people start watching them. Now the demand for their music has risen, and you can’t watch them for £4 any more, you have to go and watch them play in the main city arena and tickets are £25. Those new fans of the band have directly affected your welfare, because now it costs you more to watch the bank you like. As this effect on your welfare is transmitted through the price system, it is not an externality.

Now what about if one of these keen new fans moves into the flat next door to you and starts playing their music at top volume all through the night. You like the band, but you don’t like the music so much that you want to be kept up all night. This time your welfare has been affected in a way that is not transmitted by the price system, it’s just the annoyance of the loud music. This is an externality.

Notice as well that an externality is the impact on someone else – a different party – that did not agree to the action causing the impact. Externalities can be either positive or negative, they can be costs or benefits, but they are costs and benefits borne by someone else, not the person or firm carrying out the action causing them.

Positive externalities include the benefits of research and development, or training of new staff. When a firm invents some new technology, it may well enjoy big profits from the sales of the technology, but that technology might enable other firms to now become more productive and these gains aren’t captured by the original firm. When a firm hires a graduate and puts them through an expensive training scheme then the graduate leaves for a rival (common in fields like accountancy and law) the rival firm enjoys the benefit of the graduate’s training, but they didn’t provide it in the first place. So when a firm trains a worker the firm is not only creating a potential benefit for itself while it employs the worker, but there could be some benefit enjoyed by a rival firm down the line.

Negative externalities often come in the form of pollution – environmental damage, noise pollution, visual pollution and so on. When the polluter is affecting the lives of someone else, then it is an externality. A firm might keep down its own costs by not investing in technology to stop polluting the water, but there may be local residents that now have polluted water and face higher costs of getting clean water. The polluter has imposed an external cost on other parties.

Sometimes externalities can be quite subtle. If you put an expensive extension on your house and do your garden up so that it looks good, then one of your neighbours might like looking at it, and it makes him feel good, so it’s a positive externality to him. But one of your other neighbours might hate it or feel jealous so it’s a negative externality to him. It might end up making the street look better which helps push up the value of the neighbours’ houses. This is a positive externality to them because although it is a benefit expressed in prices, it is not expressed through the price of the action taken that caused the externality – the price you had to pay for it wasn’t affected by the way it would change the value of your neighbours houses.

There are four characteristics of externalities to remember:

1. They can be produced by individuals as well as firms.
2. There is a reciprocal aspect – someone might not like noisy neighbours but their complaints might annoy the ones making the noise.
3. Externalities can be positive or negative.
4. Zero pollution is not as a general rule socially desirable, because if you want to eliminate all negative externalities and pollution it often means not producing anything.

Because the effects lie outside the price system there is a missing market for externalities. If someone pollutes the atmosphere, they are effectively using up the commodity “clean air”. If clean air were a typical commodity its price would be determined by supply and demand, and it would be used efficiently because the polluter would have to weigh up whether the benefits of the good produced outweighed the cost of the pollution. But as there is no market for clean air, the polluter does not have to pay anything to use it up, so they treat its price as if it were zero. If the market for a commodity is missing we cannot rely on market forces to provide it efficiently. If somebody owned the resource (eg “clean air”) then they could charge for the privilege of using it, and that would give the polluter an incentive not to pollute too much.

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