Does Anyone Understand Externalities?

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People love talking about externalities and appealing to externality-type arguments. However, I think that sometimes people confuse what we might call general equilibrium effects with externalities. Sometimes these general equilibrium effects are referred to as “pecuniary externalities”, which might further exacerbates the confusion.

I think that the problem is how externalities are often defined. People tend to define externalities as a cost that is incurred by a third party that isn’t taken into account by the parties engaged in the actual market transaction. Okay, great that sounds easy enough.

Not only does the definition sound easy, but economists have examples at the ready. They talk about the fishery downriver from the polluting factory. The factory produces goods and sells them to someone else. However, neither the factory nor its customers internalize the cost of the pollution that is put into the river. This is a cost to the fishery therefore this is an externality.

So far, so good.

However, there are other arguments that seem to fit the definition that I used. Let’s consider some other examples.

• I walk into a store and I buy the last candy bar on the shelf. I benefit since I clearly value the candy bar at least as much as the next best alternative. The store benefits because they sell the candy bar for at least as much as the marginal cost. But what about the third party? What about the person who walks into the store after me to purchase a candy bar, but there are none left on the shelf? Did not the store and I impose a cost on this third party that we failed to take into account?

• Or suppose that Ford comes out with a new electric car. I had been planning to buy a Tesla, but I buy the Ford instead. I am better off. Ford is better off. At the same time, didn’t we impose a cost on Tesla? After all, they lost a sale (and therefore some profit) as a result of Ford’s production.

• There are real world examples of these arguments. Some politicians in the state of New York recently argued that bitcoin mining imposed an externality on electricity consumers. The argument was that the arrival of bitcoin mining increased the demand for electricity. As a result, consumers had to pay higher prices for electricity.

Are any of these examples what we mean when we discuss externalities?

The first example is an example of rivalry in consumption. If I consume a good, you cannot consume the same good. The fact that it is the last candy bar is a bit of a red herring.

The second example is simply an example of competition. Ford and Tesla are competing for customers of electric vehicles.

The third example is an example of a relative price effect. An increase in the demand for electricity causes the price of electricity to rise relative to other goods. Sure, this forces some (if not all) previous consumers to consume less electricity. However, this is because they are not willing to buy as much at this new price. That is just supply and demand. There is always some buyer for whom the price is above their willingness to pay.

The reason that people get confused is that it seems like there is some “harm” that is being done to a third party. In each case, this is simply an example of a third party not getting what they want. The person who walks into the store after me wanted a candy bar. Tesla wanted to sell me a car. People in New York wanted to pay less for electricity. But we can’t all have everything that we want all the time. Recourses are scarce. They are not in unlimited supply. This is the starting point of all economic inquiry. There is no point in studying the allocation of resources if everyone could have everything they wanted all the time.

You might object and argue that the factory-fishery example is just the same thing as the Ford-Tesla example. The factory’s pollution reduces the fisheries profits. Ford’s new vehicle reduces Tesla’s profits. Isn’t this the same thing? Not really. In the factory-fishery example, the factory’s pollution affects the production process. Tesla’s production process is not effected by my decision to buy a Ford.

This distinction is important. The Ford/Tesla example is one of competition. This competition causes them to compete for resources. If Tesla starts producing electric cars first and then Ford decides to produce electric cars, they will not only compete for sales, but they will compete for workers. Ford’s entry tends to drive up the cost of those workers. Now, this could be construed to say that my choice of a Ford is increasing Tesla’s costs, reducing its sales, and its profits. Nonetheless, my transaction with Ford does not affect Tesla’s ability to produce. In fact, the change in the price of inputs will tend help in terms of allocative efficiency. If some firms are willing to pay higher wages, that signals that this is where workers are valued most.

In the factory-fishery example, the pollution of the river might make it harder for fish to survive or it might make it harder to raise and catch fish (or all of the above). This increases the marginal cost of raising and catching fish. However, this increased cost is not because the factory has some better use for fish or is competing with the fishery to acquire fish, but rather that the factory is dumping harmful chemicals into the water (and ignoring the cost). This affects the fishery’s ability to produce.

In short, when thinking about production externalities, it is not whether the actions of market participants affect the profits of some third party, but rather whether these actions affect the production function of the third party.