Externalities

E Externalities consumption of schooling leads to a reduction in the crime rate, a positive externality (Lochner and Ursula W. Kreitmair1 and Jacob S. Bower-Bir2,3 Moretti 2004). Steel production generates air pol- 1 University of Nebraska, Lincoln, lution, a negative externality. You receive a bene- NE, USA fit living among educated citizens and you pay a 2 Department of Public Policy and Administration, cost living downwind of a steel plant, but neither American University in Cairo, Cairo, Egypt is likely to influence the market price of schooling 3 Ostrom Workshop in Political Theory and Policy or steel without some coordination or intervention Analysis, Indiana University, Bloomington, (for reasons discussed below). The production or IN, USA consumption of a good can result in multiple, poten- tially opposite externalities with varying effects across a population. Air pollution from steel pro- Synonyms duction will harm those with respiratory illnesses more than their healthy neighbors and may even Neighborhood effects; Spillover effects; Spillovers benefit air-filtration salespersons. One can frame most negative externalities as positive externalities, or vice versa, by flipping the spillover’s reference Definition point. For example, air pollution is a net-negative externality from steel production, and cleaner air is Externalities are the “[b]enefits or costs of an a positive externality of reduced steel production. individual’s activity that the individual does not receive or bear” (Ekelund et al. 2006, p. 415). They arise whenever the actions of one person Introduction affect the welfare of another. There are positive (when others receive a benefit) and negative (when While the concept of externalities is not contro- others are burdened with costs) externalities that versial, their consequences for market efficiency, may arise from production and consumption deci- and resultant recommendations for policy inter- sions. When the production or consumption of a ventions, have spurred a wealth of research and good carries externalities, the effects spill over out- considerable disagreement among academics and side of the market and consequently are not fully laypersons alike. reflected in the good’s price. Widespread # Springer International Publishing AG 2017 T.K. Shackelford, V.A. Weekes-Shackelford (eds.), Encyclopedia of Evolutionary Psychological Science, DOI 10.1007/978-3-319-16999-6_1597-1 2 Externalities Failing Markets and Policy Responses its overproduction/consumption (e.g., too many people texting while driving) because the Market Failure decision-maker reaps all the benefits of her Pareto efficiency, or so-called social welfare max- actions but shares their costs across society. In imizing outcomes, wherein no individual can be both instances, the market has failed to deliver made better off without someone else being made the (economically defined) optimal outcome. worse off, is a common goal for welfare econo- mists (though it is not necessarily sufficient for a Government Responses to Externalities normatively appealing distribution of resources) To increase social welfare, public policymakers [A]. Provided a host of conditions are met, com- seek to correct externality-caused market failures petitive markets arrive at such outcomes. One of with a variety of instruments, each with their own these conditions is that the costs or benefits from (dis)advantages, enthusiastic champions, and ve- producing/consuming a good accrue only to the hement opponents [D]. Among the most politi- decision-maker – that is, there are no externalities. cally heated, governments can counteract the In the presence of externalities, the market “fails” under-/over-provision of positive/negative exter- to maximize social welfare as individuals are nalities through “command-and-control” tools, driven to underproduce/consume goods with posi- mandating a specific level or method of the tive externalities and overproduce/consume goods good’s production/consumption for each actor with negative externalities. Although Pareto effi- and levying fines if standards are not met. In the cient outcomes are still possible, the market by United States, the Affordable Care Act (ACA, aka itself will not arrive at that distribution of Obamacare) was such an attempt, aimed at enroll- resources. ing in health insurance – with its positive social To see why this happens, consider that individ- spillovers – citizens who were either unable or uals strive to maximize their welfare, broadly unwilling to purchase it. The ACA’s “individual conceived [B]. They do this by engaging in a mandate” requires individuals to purchase health desired action until its private marginal benefit insurance or face a fine. When policymakers deem equals its private marginal cost. At that point, externalities sufficiently large, government agen- net benefit is zero, and additional production/con- cies may take over production to fully regulate the sumption is undesirable as most actions have spillovers, as is the case with single-payer healthcare increasing marginal costs and decreasing mar- in countries such as Canada, the UK, and France. ginal benefits [C]. Absent externalities, an action’s Although command-and-control approaches inspire social marginal costs and benefits – its private strong ideological- and efficiency-based criticisms, marginal costs and benefits summed across all there are instances when these tools provide the affected individuals – are the same as its private most (cost-) effective solutions (Cole and Grossman marginal costs and benefits because the decision- 1999). As such, the question is not whether to maker is the sole beneficiary of her action. Not so employ command-and-control but under what in the presence of externalities when private circumstances. actions help or hurt outsiders, too. With positive Policymakers can also rely on market forces to externalities, an action’s social marginal benefit is improve social welfare by (i) artificially aligning greater than its private marginal benefit. If individ- private and public marginal costs and benefits via uals do not consider the public ramifications of their a per-unit tax or subsidy on the externality or decisions, markets will promote underproduction/ (ii) capping an externality at the socially optimal consumption of the good or service in question level and then allowing producers/consumers to (e.g., too few vaccinations) because the decision- trade rights to produce/consume the externality maker bears all the costs of her actions but shares among themselves. These “market-based” instru- their benefits. With negative externalities, an ments rely on government agencies to set the price action’s social marginal cost is greater than its or the quantity of the externality but let the market private marginal cost, and the market will promote reduce compliance costs [E]. For example, a Externalities 3 Pigouvian tax forces steel mills to internalize the their and society’s welfare (Thaler and Sunstein social cost of their production externality by tax- 2008). For example, individuals often struggle to ing each ton of air pollution they generate. The align their immediate preferences and behaviors value of that tax will equal the difference between with their long-term goals. Consequently, rela- (i) the marginal cost of one ton of pollution to tively few individuals join employer-offered society, which is relatively high, and (ii) the mar- retirement saving programs despite their long- ginal cost of one ton of pollution to the mill, which term advantages, and many who do participate is relatively low. Making the mills cover the full do not save enough for the kind of retirement cost of their actions yields efficient production deci- they want. The cognitive and disciplinary sions (Pigou 1920). Similarly, cap and trade sys- demands of forgoing present consumption for tems mandate the amount of an externality that an greater future consumption are challenging even industry may produce but then allow producers for people who care about their retirement. But within that industry to efficiently distribute exter- what if the decision were reversed? Policymakers nality production among themselves through a can make saving, rather than deciding on whether market. For example, in the 1990s, the Environ- and how much to save, the default so that individ- mental Protection Agency (EPA) capped the uals have to opt out rather than opt amount of sulfur dioxide the US energy industry in. Automatically enrolling employees in such pro- could emit. It then distributed emission permits to grams and periodically increasing the minimum the individual energy providers, who could trade contribution rate substantially increase retirement those permits, meaning providers who found it savings (Benartzi and Thaler 2013). This carries cheapest to reduce emissions could sell their permits benefits for savers because their lifetime consump- to higher-cost emitters. This approach resulted in tion is now more even across time, and it benefits more cost-effective emission reductions than their compatriots by reducing the costs of com- would have occurred via command-and-control munal elderly care. Policies of this sort, which rest (Keohane 2007). on the growing cognitive and behavioral science In general, market-based interventions are literatures, highlight the importance of nuanced more cost-effective than strict command and con- institutional design to individual and social wel- trol because the most efficient actors will be the fare (Ostrom 2009), thus expanding the debate ones to achieve the abatement in negative exter- beyond state versus market and market instru- nalities or the provision of positive externalities. ments versus command-and-control [G]. The distribution of regulatory burden is different from that of command-and-control approaches, Coasean Bargaining which mandate individual targets (Baumol and Because government is not subject to the same Oates 1988). In addition, market-based instru- profit-based efficiency motivation as industry, and ments encourage innovation as there is now an because calculating private and social marginal incentive to lower the cost of reducing/producing costs and benefits can be difficult, some academ- a negative/positive externality. However, for a ics argue that government intervention may be number of reasons, market approaches have not worse than the market failures it tries to correct. always received the widespread application that In situations where enforceable property rights these benefits might warrant [F]. exist and there are few barriers (i.e., “transaction Market-based interventions are attractive, but costs”) to individuals bargaining, parties affected humans systematically deviate from the rational by externalities may resolve market failures them- actor models that undergird them (Kahneman selves, without recourse to the interventions dis- 2011). Policymakers can leverage these devia- cussed earlier (Coase 1960). To illustrate this tions from rational behavior by restructuring the approach, consider if our steel mill was located decision-making environment (without limiting upstream from a fishery. In the absence of regula- options available to the decision-maker) so that tion, the steel mill imposes a negative externality it nudges people into making choices that improve on the fishery in the form of water pollution. If, 4 Externalities however, the fishery possesses property rights not raise enough funds to stop the mill’s polluting, over clean water, its owners can demand compen- making everyone worse off than if all or even a sation from the steel mill for the damages to their few fisheries had shouldered the financial burden. fish stock. The steel mill is thus forced to include Game theory predicts that there is little chance of in their production decisions the marginal cost cooperation in social situations centered around that their behavior imposes on the fishery, thereby such externalities – discouraging given the num- aligning private and social marginal costs and ber of situations that display this general incentive benefits and ensuring an efficient market outcome structure (e.g., charitable giving, open-access [H]. Here, government’s role may be limited to computer code, environmental resource manage- establishing and maintaining the conditions under ment, student group projects, etc.) [J]. which the market can overcome potential failures. Remarkably, the externality-borne incentives Among these conditions are well-defined property at the heart of the market failures discussed earlier rights, rule of law, and so forth. There exist, how- are the same as those leading to the cooperative ever, many situations where property rights are breakdowns just laid out. (Technically, defecting difficult to enforce, or where transactions costs in a prisoner’s dilemma constitutes a market fail- are high due to numerous parties involved in ure and full cooperation the Pareto optimum.) negotiations, such that efficient outcomes may When studying cooperation, however, researchers require more extensive intervention. focus less on externally imposed market correc- tions (such as command-and-control tools or market-based instruments) in favor of studying Externalities and Cooperation the conditions under which cooperative success might be achieved endogenously (i.e., from Externalities are essential to understanding coop- within the system as it already exists), often via eration (or lack thereof) on matters of social import. group-imposed incentives. For instance, behav- Free riding on others’ efforts or investments is often ioral economists and psychologists research the a winning strategy when externalities are present, conditions under which individuals are willing to making cooperation difficult. To illustrate, let us cooperate in creating/reducing goods with posi- return to the Coasean bargaining example, but tive/negative externalities (e.g., see Chaudhuri with a twist: the steel mill, now with rights to 2011), finding that individuals vary widely in pollute the river, finds itself upstream of numerous (i) their proclivities to cooperate (e.g., fisheries all equally affected by its pollution. No Fischbacher and Gächter 2010) and/or (ii) in fishery alone can compensate the steel mill for its their expectations of how others might respond reduced production; they must cooperate to raise to cooperation on their part. For example, some sufficient funds. All of the fishery owners want a display ostensibly altruistic behavior (i.e., cleaner river, but each knows she will enjoy its cooperating regardless of what others are doing) benefits whether or not she contributes toward the or conditionally cooperative behavior (i.e., mill’s compensatory sum, so long as that sum is cooperating if others are too), suggesting that reached. The environmental improvement is a cooperative success is not impossible [K]. Even positive externality and its benefits non- when group composition is not favorable to coop- excludable. Its costs, however, can be shared and eration (e.g., when few altruists are present), insti- shirked. The fisheries benefit most overall if all tutional settings (e.g., how much oversight there fisheries pay to compensate the steel mill to is, whether punishment is possible, how benefits reduce pollution as much as possible, but each are distributed, etc.) can discourage free riding on fishery owner has an incentive to free ride – with- others’ efforts to produce/reduce goods with hold her funds and hope that the other owners will externalities (Ostrom et al. 1994). These institu- make up for her lost contribution [I]. Because all tions then mirror, in part, the exogenous market the fishery owners have the same incentive to free corrections implemented by government officials, ride, there is a real possibility that the fisheries will albeit with more reliance on self-governance. Externalities 5 Conclusion Connections and Extensions While the theory on externalities is well established, [A] Well-functioning markets arrive at a Pareto the real-world implications are, unsurprisingly, con- efficient resource distribution, of which there may troversial. Externalities are prevalent in society – be many, but there is no guarantee that the specific few decisions do not impact those around us. But distribution of resources is politically or morally society often struggles over whether and how to palatable. In addition, the “liberal paradox” shows address externalities. Strict economic efficiency the impossibility of achieving Pareto efficiencies analyses, probably the most common approach while respecting individual liberties. to evaluate how to tackle externalities, may not [B] The classic rational choice model of human be sufficient to make policy decisions – in part decision-making allows individuals to receive because analyses on the cost-effectiveness of (dis)utility from numerous and often non- solutions to problems that arise out of externalities pecuniary sources such as social standing, kudos often disregard costs and constraints that go be- from others, the warm fuzzy feeling you get from yond economic considerations, such as political sharing/voting/volunteering, etc. and is thus broad realities and societal preferences (Richards 1999). in its view of what motivates individuals to act. There are a variety of reasons why society might However, it does posit (at times unrealistically) often prefer one approach over a more efficient one. that actors have the time, desire, and cognitive Further, there is often disagreement over capacity to calculate the costs and benefits asso- whether something constitutes an externality in ciated with available actions, allowing them to the first place. People will disagree over how choose the course that results in maximum net “public” a problem is. The recent debate regarding utility. Consequently, researchers have identified gay marriage demonstrates this well. Some advo- instances when individuals violate the classic cates argue that no one but the consenting indi- model’s assumptions and behavioral predictions viduals marrying are affected by the ability to (Kahneman 2011), and subsequent extensions to lawfully wed, while opponents argue that such the rational choice approach have incorporated relationships spill over to them, undermining their general and context-specific bounds on human own heterosexual coupling. Moreover, some people cognition. Still, given the model’s intuitive may view gay marriage as a right (constitutional, appeal, its mathematical tractability, and its ability human, or otherwise). In this case, these individ- to provide clear and, in some cases, accurate pre- uals will argue that economic efficiency criteria dictions, the classic rational choice model remains are irrelevant – the debate over whether external- at the core of public policy analysis. ities exist ceases to be of importance. Additional [C] “Marginal” means consuming or creating a philosophical issues arise in the debate over single unit of a good or service on top of what whether animal welfare in, say, food production already exists. For example, building an addi- or product testing constitutes a negative external- tional floor in a skyscraper costs more than the ity even though humans are not directly affected. last because it requires reinforcing the foundation If so, does it warrant increased regulation with and lower levels (increasing marginal cost), and potential impacts on the cost of food and welfare eating an additional scoop of ice cream yields less implications for food producers? joy than its predecessor (decreasing marginal Externalities exist, and economic theory gives benefit). us many of the tools to assess and regulate their [D] Market failure stemming from externalities efficient distribution. However, the realities of de- and their subsequent violations of the Pareto con- signing effective policies are complicated, in part ditions is one of the main motivations for public because of the difficulty of grappling with the policy intervention in the economy, along with underlying questions about how to conceive of lowering transaction costs and changing resource goods and how far afield we are willing to look allocations on moral grounds (Weimer and Vining for their impacts. 2017). However, there are several requirements 6 Externalities for Pareto efficiency beyond those related to exter- strategies and preferences may provide an advan- nalities, and they also frequently go unmet. Thus, tage (Axelrod 1984). almost all markets exhibit market failure to vary- ing degrees, and economists and policymakers spend much time and effort determining which Cross-References market failures government should try to correct. [E] Compliance costs refer to the resources (e.g., ▶ Cooperation Indirect Costs time and money) spent by industry (or individual ▶ Economic Decisions consumers) to comply with a given regulation. ▶ Game Theory [F] Among the reasons for the relative lack of ▶ Indirect Reciprocity market-based instruments are industry opposition ▶ Prisoner’s Dilemma to regulation generaly, regulator experience with ▶ Theory of Games and Economic Behavior command-and-control over market-based instru- ments, and legislators-who are often trained law- yers-preferring policy rooted in law rather than References economics (Stavins 1998). [G] It is important to distinguish between the state Axelrod, R. M. (1984). The evolution of cooperation. New York: Basic Books. versus market debate and the market instruments Baumol, W. J., & Oates, W. E. (1988). The theory of versus command and control debate. The first environmental policy (2nd ed.). New York: Cambridge contests whether government should intervene at University Press. all. Contrast this with the second debate, where Benartzi, S., & Thaler, R. H. (2013). Behavioral economics and the retirement savings crisis. Science, 339(6124), the issue is not intervention per se, but what form 1152–1153. the intervention should take. Market-based instru- Chaudhuri, A. (2011). Sustaining cooperation in laboratory ments are still government interventions, but do public goods experiments: A selective survey of the not mandate individual behavior as command- literature. Experimental Economics, 14, 47–83. Coase, R. H. (1960). The problem of social cost. The and-control would. Journal of Law & Economics, 3, 1–44. [H] Efficient market outcomes are not contingent Cole, D. H., & Grossman, P. Z. (1999). When is command- upon which party holds property rights (Coase and-control efficient? Institutions, technology, and the 1960). If the steel mill has property rights over comparative efficiency of alternative regulatory re- gimes for environmental protection. Wisconsin Law the water, then the fishery pays it to reduce its Review, 5, 887. pollution, but the final level of pollution will be Ekelund, R. B., Jr., Resseler, R. W., & Tollison, R. D. (2006). the same as when the fishery holds the rights. Microeconomics: Private markets and public choices [I] This assumes constant marginal costs and ben- (7th ed.). Boston: Addison Wesley. Fischbacher, U., & Gächter, S. (2010). Social preferences, efits of pollution reduction. beliefs, and the dynamics of free riding in public goods [J] Scenarios like these, where community wel- experiments. The American Economic Review, 100(1), fare is at odds with individual incentives, are called 541–556. “social dilemmas.” To study behavior in these set- Kahneman, D. (2011). Thinking, fast and slow. New York: Farrar, Straus and Groux. tings, researchers often abstract these scenarios as Keohane, N. O. (2007). Cost savings from allowance trad- n-player prisoner’s dilemmas and public goods ing in the 1990 Clean Air Act: Estimates from a choice- games. based model. In J. Freeman & C. D. Kolstad (Eds.), [K] Evolutionary game theory provides justifica- Moving to markets in environmental regulation: Les- sons from twenty years of experience (pp. 194–229). tion for why these preferences may exist despite New York: Oxford University Press. these preferences often leading to less desirable Lochner, L., & Moretti, E. (2004). The effect of education outcomes for the individual. In repeated games, on crime: Evidence from prison inmates, arrests, and cooperating when others cooperate can lead to self-reports. The American Economic Review, 94(1), 155–189. mutually beneficial outcomes over mutual defec- Ostrom, E. (2009). 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