Externalities in Economics

Externality is yet another significant source of market failure. It is owing to the lack of property rights that externality arises. According to Jaen (2005), by externality we mean the situation when the cost or benefits related to a transaction not only affects the transactors but also the other parties which is called party effect. Non-inclusion of such effect in decision making causes externality and hence market failure.

Jaen added that an example of this is pollution from factories which adversely affects the health of the people in the neighborhood.

But such a cost is not included in the estimation of cost of production; accordingly there is increase supply. This is called negative or harmful externality. Jaen (2005) added that externality could be beneficial as well and he cited an example, the painting of house by individual A may lead in its market value and also that of the other properties in the neighborhood.

Thus the benefit accrues to the third party; this is an example of positive externality.

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Before explaining externality further, we must make a distinction between private cost or benefit and social cost or benefit. In a given society, the resources are said to be optimally allocated when the social marginal cost is equal to the social marginal benefit. Free markets would optimally allocate the resources when private costs are equal to social costs and private benefits are the same as social benefits (Jaen, 2005).

There would be negative externality when social cost exceeds private costs and positive or beneficial externality when social benefits exceed private benefits.

_________________________ Jaen, T. R. & Ohri, V. K. (2005). Principles of Microeconomics. Page 324 - 332 Externalities arise when one economic agent does not compensate others for his actions which may directly affect their consumption or production possibilities. Smokers, who do not, for example, pay for increasing others’ risk of cancer, or for the discomfort they may cause, produce externalities.

According to Miyao & Kanemoto (1987), urban life is filled with examples of externalities: manufacturing producers may cause air and water pollution which negatively affects residence and other producer; some individuals may have racial prejudice against certain ethnic groups; a household may benefit from beautiful gardens of its neighbors; firms often prefer to locate in larger cities because of proximity to other firms; and an additional traveler in a congested road imposes external cost on other travelers by slowing them down.

According to the Fundamental Theorem of Welfare Economics, a competitive equilibrium is efficient in the Pareto optimal sense if all goods are private goods and no externalities exist. This result, however, breaks down if there are externalities. An individual decision maker who generates externalities does not take into account actual external cost or benefits imposed on others; his decision must therefore be corrected to account for external effects.

Externalities, thus present a case of potential market failure where go government intervention may be called for to guide a decentralized market system toward a point where resource allocation is efficient (Miyao & Kanemoto, 1987). It is however, too early to jump to the conclusion that government action are always justified when there are externalities; for example, individual who suffer from water pollution have an incentive to get together and bribe firms to reduce pollution. The reason why this may not happen is that the transaction cost to set up a market for pollution may be too high.

___________________________ Miyao, T. & Kanemoto, Y. (1987). Urban Dynamics and Urban Externalities. Page 100 According to Miyao & Kanemoto (1987), if the government has to incur the same transactions cost as private individuals, then government intervention cannot improve resource allocation. Even if government intervention is justifiable, the government has to choose an appropriate policy among alternative policy measures. For example, introducing a Pigouvian tax/subsidy system is one way of modifying individuals’ action to achieve an efficient allocation (Miyao & Kanemoto, 1987).

A tax` placed on pollution will ten to reduce the amount of externality. If a corrective tax is set equal to the marginal externality cost suffered by others, an efficient allocation is achieved. One problem with the Pigouvian tax/subsidy, however, is that it usually requires high administrative cost. As Miyao & Kanemoto (1987) stated, in some cases, direct regulation of private activities such as ceiling on pollution emissions and a control of land use may be less costly; moreover the government might also have to resort to cruder measures.

For example, a Pigouvian tax/subsidy system for traffic congestion requires congestion tolls whose levels are different for different roads depending on the severity of congestion. External effects have been studied by economist ever since the days of Marshall & Pigou; along with development of the field environmental economics, the theory of externalities has remained of great and growing importance in economic science (Jeroen 1999).

As Jeroen (1999) quoted, “indeed it is fair to say that, starting from the traditional neoclassical economic framework, the most logical way to look at problems of environmental pollution is from the perspective of external cost”. It was also added that “however, although economist have been investigating the concept of externalities for a long time, both theoretically and empirically, ______________________________ Miyao, T. & Kanemoto, Y. (1987). Urban Dynamics and Urban Externalities. Page 100 Jeroen, C. & van den Bergh, J. M. (1999). Handbook of Environmental and Resource Economics.

New York: Edward Elgar Publishing. externalities still prove to be an area of slippery ice”. Frequently, one finds fuzzy discussions on the discussions on the policy implications of external cost. According to Jeroen (1999), this may often result from, for instance, mixing up equity and allocative efficiencies arguments , from mistaking pecuniary externalities for true or technological externalities from some sense of compassion with the victims of externalities on equity ground, leading to pleas for ‘compensation’ which may often be unwarranted from the perspective of allocative efficiency

The Concept of Environmental Externalities in Economics In recent years, economist have reluctantly added new variable in their economic thinking to account for the side-effects induced by the production of goods (Hokikian, 2002). They have labeled the parameter “externalities” (normally used in plural due to its multiple effects) because it usually affects, costwise, people other than who are directly buying, selling, or using the goods in question.

When nuclear reactors produce electricity, we are gratified because we put electricity to such uses as washing and drying dishes and clothes. But when the nuclear generate highly reactive by-products, we are annoyed because the nuclear wastes are dangerous to our health. Economist call these unwanted nuclear waste externalities, because most of the cost associated with storing, regulating, and transporting them are not added directly into the cost of electricity.

Pollution from economic point of view is the production of waste, dirt, noise, and other things we do not want. As Hokikian (2002) illustrated, for example, we do want steel and cement, but we do not want the smoke produced by the output processes; we do want mechanical energy from heat engines, but we do not want the released heat, which we call thermal pollution. _____________________________ Hokikian, J. (2002). The Science of Disorder: Understanding the Complexity, Uncertainty, and Pollution in our World. page 161

Economists’ externalities are nature’s entropy. Since the middle of nineteenth century, we have known that all processes increase in entropy; yet only recently have humans become a highly entropic creature, generating massive amounts of entropy. Externalities have become a major variable in industrial societies; as humans advanced technologically, we became a major producers of waste products that through the years have gradually accumulated to the point when we can no longer ignore their existence (Hokikian, 2002).

Paretian Welfare Criteria and Market Failures Mainstream neoclassical micro and welfare economics theories suggest that governments should in principle be reserved in intervening directly in the economic process (Jeroen, 1999). According to Jeroen (1999), it is broadly accepted that economic science should aim at providing value free descriptions and analyses of human choice, and the associated social processes, under conditions of scarcity.

As it is not possible to construct a value-free social welfare function according to some ethically objective criterion, welfare economics has an inherent tendency to rely on quite humble criteria for the evaluation of different possible outcomes of economic processes, for instance under different forms of government interventions. As Jeroen (1999) stated, although the concept of external effects is widely used in economics, there seems to be some confusion about its exact definition and interpretation.

He added that, it is commonly recognized that externalities are an important form of market failure. ______________________________ Hokikian, J. (2002). The Science of Disorder: Understanding the Complexity, Uncertainty, and Pollution in our World. page 161. Jeroen, C. & van den Bergh, J. M. (1999). Handbook of Environmental and Resource Economics. page 197. their existence leads to a deviation from the first-best neoclassical world, in which the price mechanism takes care of an efficient resource allocation (Pareto Efficiency).

According to Jeroen (1999), in the presence of ext3ernalities, market prices do not reflect full social costs or benefits, and, for instance, regulatory taxes or subsidies are called for to restore the efficient workings for the market mechanism. Furthermore, it is generally accepted that the source of externalities is typically to be found in the absence of well defined property rights (qtd. in Jeroen, 1999). Consequently, the theory of is often applied in environmental economics: environmental quality is a typical good from which property rights are not defined and hence no market exists.

These commonplaces may clearly indicate the causes and consequences of external effects, but still leave the definition unclear; such a definition can be as follows: an external effect exists when an actor’s utility function contains a real variable whose actual value depends on the behavior of another actor, who does not take this effect of his behavior into account in his decision making process. According to Jeroen (1999), the above definition concerns technological externalities as opposed to pecuniary externalities.

These latter which are ruled out by considering real variables only (that is, excluding monetary variables), do not lead to shifts of production and utility functions, but merely to movements along these functions. Consequently, externalities as defined above are potentially ‘Pareto relevant’ (if costs of correcting for the market failure do not exceed the welfare gains to be obtained), whereas pecuniary externalities are not, because they do not reflect a failing market. As Jeroen stated, the final condition in the

__________________________ Jeroen, C. & van den Bergh, J. M. (1999). Handbook of Environmental and Resource Economics. page 197. definition distinguishes externalities from other types of unpriced interactions, such as barter, violence, jealousy, altruism or good-will promoting activities (for instance , handing out samples as products as part of a commercial campaign). Such phenomena differ fundamentally from external effects, both in a theoretical and in a policy-relevance sense.

There have always been economist interested in positive or negative externalities; however, they largely been marginalized within the profession as externalities were seen as market failure that needs to be corrected or avoided (Maiser & Sedlacek, 2004). The consequences that recent literature has demonstrated also made economist shy away for along time from accepting externalities as integral part of the economic system. If economist want to understand the growth of an economy over time, they need t allow for externalities.

Based on Maiser & Sedlacek (2004), these externalities lead to imperfect competition and tend to agglomerate production at certain locations in the economy. They added that, the resulting spatial structure leads to specialization, transportation and further externalities. This moves the spatial perspective closer to the core of economics. “As it turns out, if we can explain geographical concentration, then we can go along way toward explaining important aspects of international trade and economic growth (qtd. in Maiser & Sedlacek, 2004).

The Influence of Government Policy on the Choice of Production Practices and Chemical Use Government influence on the choice agricultural production practices and the attendant use of chemicals has a variety of forms. Before exploring these alternatives, it is important to __________________________ Maiser, G. & Sedlacek, S. (2004). Spillovers and Innovations: Space, Environment, and the Economy. page 11. understand the rational for government intervention: externalities arising from the interaction between the agricultural sector and the rest of society.

Externalities exist in situations where the activities of an economic agent (qtd. in Uri, 2005). As what Uri (2005) stated, consider the application by the farmer of pesticides that runoff into surface drinking water supplies and are ingested by individuals. Drinking water with high concentrations of pesticides has suspected risk and associated cost to human health; this is an example of a negative externality because the action of the farmer adversely affects the welfare of consumers. The absence of externalities is one of the conditions required for competitive markets to achieve an efficient allocation of resources.

This is not meant to imply, however, that the presence of an externality requires government intervention. According to Uri (2005), in many situations, the involved parties may negotiate a solution that will address the externality problem and result in an efficient resource allocation. For example, restricting pesticide spaying during certain times to minimize community exposure to drifting pesticides can be the result of voluntary agreement between a farmer and the residents surrounding the farmer’s cropland.

There are, however, externalities where the interaction between private parties does not lead to an efficient allocation of resources. Government intervention may be consider in these instances even though there is no guarantee that the intervention will lead to an enhance efficiency; such situations are referred to as externality problem or market failure (Uri, 2005). Uri, N. D. (2005). Agriculture and the Environment. New York: page 60.

Government intervention can take a variety of forms including, taxes, subsidies, subsidies, and educational, and technical assistance, as Uri (2005) stated. There are other situations where intervention is justified on the basis of distributional equity considerations. Even if an efficient resource allocation could be obtained through private and public approaches, the solution could be sub-optimal from society’s perspective if it results from equities in terms of income distribution or the burden of regulation (Uri, 2005).

Because distributional inequity is so highly subjective, however, little discussion will be devoted to it in what follows. As previously noted externalities play a central role in the economics of the interaction between the agricultural sector and the stock of natural resources. According to Uri (2005), to mitigate the impact of externalities, a number of policy options are available to the government; these policy options in general have the potential to impact the production practices adopted by farmers and the use of agricultural chemicals.