[Smart Economics] Unintended Influence: Externalities

Exhaust fumes and traffic congestion... How should we solve “externalities”?

On a midsummer night, a couple is setting off fireworks on the beach. They put considerable effort into preparing the display to decorate the summer night sky with dazzling colors and shapes. They searched for and compared different kinds of fireworks, selected safe, high-quality products, and bought them at great expense. Then they transported them to the beach and put on a splendid fireworks show. Anyone who happened to be nearby and saw the display was an unintentional beneficiary. Without making any effort at all, they gained a wonderful summer-night memory.

But fireworks can also cause harm. Consider local resident Mr. A, who returned home exhausted after working late. Just as he was finally about to fall asleep, the fireworks began. The brilliant flashes and loud noises jolted him fully awake, and even after the display ended, he could not easily fall back asleep and spent the night tossing and turning. Naturally, the next day his work performance was bound to suffer.

Externalities: Being affected by someone else’s actions

This kind of phenomenon—where, unintentionally, someone’s actions have either a positive or negative effect on others—is called an “external effect” or “externality” in economics. An externality occurs when an economic activity brings unintended benefits or harm to others without any compensation being received or paid for it.

Externalities are divided into positive externalities, which confer benefits, and negative externalities, which impose harm. The case of people positively affected by the fireworks is called a positive externality, or external economy. By contrast, cases like that of local resident Mr. A, who was negatively affected, are called negative externalities, or external diseconomies.

What becomes problematic is the negative externality, that is, the external diseconomy. When economic activity unintentionally harms others, questions of responsibility and compensation become unclear.

A representative negative externality is traffic. Cars provide people with convenient mobility. That is why many people buy cars to secure freedom of movement. But the roads cars can travel on are limited. What happens when the number of cars increases on a limited road network? Naturally, traffic congestion results, and the more severe it becomes, the longer it takes everyone to reach their desired destinations. Cars were created to make travel fast and convenient, yet the more people use them, the longer travel takes and the more inconvenience they suffer. It is quite ironic.

That is not all. As the number of cars increases, tire dust and exhaust emissions also rise, worsening air pollution and causing various environmental problems. This leads to economic losses, such as increased medical expenses associated with respiratory illnesses.

The Coase Theorem: Solving externality problems through agreement and negotiation

And yet, despite all this, no one tries to take responsibility for the problem. No one is held accountable or pays for the damages caused by traffic congestion, increased exhaust emissions, air pollution, or environmental problems. The reason is that this is a negative externality—that is, it arises from actions outside the sphere of economic transactions, where transaction costs are not borne.

People have proposed various solutions to address such negative externalities. Among them, the logic of Nobel Prize-winning economist Coase was distinctive. Through the “Coase Theorem,” Coase argued that when externalities become a problem, the government need not step in; instead, individual economic actors can resolve the issue through mutual agreement and negotiation.

The Coase Theorem requires two preconditions. First, property rights must be clearly defined. Only then can gains and losses be rationally assessed, and disputes can be amicably resolved through agreement and negotiation. Second, the price mechanism must operate without transaction costs. If transaction costs arise, rational problem-solving becomes difficult. Coase argued that if these two conditions are met, the parties involved can resolve disputes arising from externalities sufficiently and rationally on their own, without government intervention. Accordingly, he saw the government’s role not as active intervention, but as ensuring that these two preconditions are upheld.

When government intervention is necessary

Of course, depending on the externality, there are cases that are difficult to leave to the private sector, such as households or firms. In problems that cross borders—that is, problems between countries—government intervention is necessary. A representative example is environmental pollution that spreads across national borders.

Take China’s yellow dust, for example. Responsibility for it cannot be pinned on any particular individual, group, or even just one specific country. Even if one country works hard to protect the environment, it will all come to nothing if another country indiscriminately emits pollutants. Nature has no borders. Polluted air and water circulate and spread to neighboring countries.

In cases like this, which cannot be solved by the efforts or laws of a single country, cross-border international cooperation is necessary. That is why governments representing their respective countries must demonstrate the wisdom to negotiate with one another and work toward solutions.

▲ Please remember

In economics, the phenomenon in which someone’s actions unintentionally have positive or negative effects on others is called an “external effect” or “externality.” Nobel Prize-winning economist Coase argued through the “Coase Theorem” that when externalities become a problem, the government need not intervene, and instead individual economic actors can resolve the issue through agreement and negotiation.

Sung-no Choi

President, Center for Free Enterprise (CFE)

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Original title: [스마트 경제 읽기] 의도하지 않은 영향력, 외부효과

Author: Sung-no Choi

Date: 2020-11-02

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=column&pn=6&idx=23209