Question

Try as we may, whether economies have markets that are laissez faire, loosely or tightly regulated, or whether the government is the major decision-maker, markets do fail. That is, they fail to register the appropriate/proper/efficient prices and quantities in the marketplace. Costs and/or benefits may, in some markets, spill over onto people outside of the market transactions – thus, the externality. Some are positive (my neighbor who lives to the left of me, has a flower garden that improves my quality of life and he’s done all the work) and some are negative (my neighbor to the right of me lowers the quality of my life with the two broken down cars he keeps on his front lawn). Noting what has been mentioned above, take a positive externality or a negative externality and explore it in detail. Examine the role of social costs and benefits, private costs and benefits, what role, if any, can the government or even the private sector play in correcting the externality, is there a free-rider problem associated with it and can it be corrected? As we attempt to correct for the externality what additional tradeoffs may the private and/or pubic sectors make? You should use graphs to help reinforce and bolster your answer.

Answer 1

(1) Social Costs and benefits , private cost and benefits

Every business activity which takes place has some benefits and costs attached to it. The benefits go both to the owners of the firm as well as to external stakeholders. In the same way the owners and the external stakeholders have to pay a cost for the activities of the business.
Social cost:-

Social cost is the sum of private cost and external cost. For example, the manufacturing cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead costs of running the plant and labor costs) reflects the private cost for the manufacturer. Water or air is also polluted as part of the process of producing the car, This is an external cost borne by those who are affected by the pollution or who value unpolluted air or water. Because the manufacturer does not pay for this external cost, and does not include this cost in the price of the car. The air pollution from driving the car is also an externality produced by the car user in the process of using his good. The driver does not compensate for the environmental damage caused by using the car.

Social-Cost is the cost to an entire society resulting from an event, an activity or a change in policy. Social cost equals the sum of private cost and external cost.

When assessing the overall impact of its commercial actions in terms of social costs, a socially responsible business operator should take into account its own production expenses, as well as any indirect expenses or damages borne by others.

• Private cost:-

It is the cost of setting up the business. The owner(s) pay for the hire of machinery, buying of materials, payments of wages. This is termed as Private Cost.

• External Cost:-

The problems that the external stakeholders have to bear due to the firm’s activity are known as external cost. Example: cleaning a river which has been polluted by a firm’s waste products. Private firms usually ignore external cost.

Social benefits:-

Social benefits are the sum of private benefits and external benefits. For example, a college decides to slash its tuition rates by half. This encourages more people to get educated. A better-educated workforce, in turn, helps businesses produce more. Thus, even though the businesses did not pay for the reduced college tuition, they still reap a positive external benefit from the college’s move. The increase in the welfare of a society that is derived from a particular course of action. Some social benefits, such as greater social justice, cannot easily be quantified.

Social benefits is the sum of private benefits and external benefits

• Private benefit:-

The benefit enjoyed by those involved in the production or consumption . For example, the revenue earned by the firm is a benefit for the owner and is termed as Private benefit.

• External benefits:-

Some firms can cause external benefits. These are the benefits to the external stakeholders due to the activity of firm. For example, a firm may train workers, which might get them better wages in other firms. These external benefits are free.

Use of cost benefit analysis in decision making

Most of us are familiar with the term ‘cost-benefit analysis’ and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it’s a like a quantified pros-and-cons list… It’s an analysis of the expected balance of benefits and costs… Cost-benefit analysis sometimes called ‘benefit–cost analysis’ is a systematic process for calculating and comparing benefits and costs of a project, decision, government policy… CBA has two purposes:

1. Determine if it’s a sound investment/decision (justification/feasibility).
2. Provide a basis for comparing investments, decisions, projects… It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs and by how much…

According to Nicole Gordon; cost-benefit analysis is used to decide if the cost of a solution and the economic benefits that would result from it are worth the risk. The main idea behind this strategy is that the benefits must exceed costs to justify the policy…

When performing a cost-benefit analysis, you make a comparative assessment of all the benefits you anticipate from your project and all the costs to introduce the project, perform it, and support the changes resulting from it. Cost-benefit analyses help you to:

• Decide whether to undertake a project or decide which of several projects to undertake.
• Frame appropriate project objectives.
• Develop appropriate before and after measures of project success.
• Prepare estimates of the resources required to perform the project work.
• Everything gets a dollar value in a cost-benefit analysis.

There are some advantages and disadvantages of cost and benefit analysis.

Advantages:-

• The main advantage of cost benefit analysis is its simplicity. You are simply looking at whether benefits outweigh costs. When you do this quantitatively, measuring the dollar amount of the benefits and the costs involved in a project, the cost benefit is very easy to see.

Disadvantage:-

• The simplicity of cost benefit analysis can paradoxically lead to complications; to gain this simplicity, you have to use a common measurement– one of the disadvantages of CBA. Determining the quantitative benefits of a project is relatively straightforward; you basically add up the costs and benefits and compare the two. However, when you factor in qualitative benefits, the picture can become more complicated.

Example:-

You are considering implementing an employee bonus program, you will obviously incur costs. In exchange, you may receive benefits like increased employee satisfaction, decreased turnover and greater productivity. The benefits are significant but difficult to compare– apples to apples– to the costs involved… A frequently made mistake is the use of non-discounted amounts for calculating the costs and benefits; typically the cost is tangible– hard and financial– while the benefits are hard and tangible, but also soft and intangible.

(2) what role, if any, can the government or even the private sector play in correcting the externality

let's talk about market failure first

Commonly cited market failures include externalities, monopoly privileges, information asymmetries and factor immobility. One easy-to-illustrate market failure is the “public good problem.” Public goods are goods or services which, if produced, the producer cannot limit its consumption to paying customers.

Public goods create market failures if some consumers decide to not pay but use the good anyway. National defense is one such public good because each citizen receives similar benefits regardless of how much they pay. It is very difficult to privately produce the optimal amount of national defense. Since governments cannot use a competitive price system to determine the correct level of national defense, this may be a market failure with no pure solution

(2)EXTERNALITIES

Positive externalities are benefits that are infeasible to charge to provide; negative externalities are costs that are infeasible to charge to not provide. Ordinarily, as Adam Smith explained, selfishness leads markets to produce whatever people want; to get rich, you have to sell what the public is eager to buy. Externalities undermine the social benefits of individual selfishness. If selfish consumers do not have to pay producers for benefits, they will not pay; and if selfish producers are not paid, they will not produce. A valuable product fails to appear.

Admittedly, the real world is rarely so stark. Most people are not perfectly selfish, and it is usually feasible to charge consumers for a fraction of the benefit they receive. Due to piracy, for example, many people who enjoy a CD fail to pay the artist, which reduces the incentive to record new CDs. But some incentive to record remains, because many find piracy inconvenient and others refrain from piracy because they believe it is wrong. The problem, then, is that externalities lead to what economists call underproduction of CDs rather than the nonexistence of CDs.

Research and development is a standard example of a positive externality, air pollution of a negative externality. Ultimately, however, the distinction is semantic. It is equivalent to say “clean air has positive externalities and so clean air is underproduced” or “dirty air has negative externalities and so dirty air is overproduced.”

Economists measure externalities the same way they measure everything else: according to human beings’ willingness to pay. If one thousand people would pay ten dollars each for cleaner air, there is a ten-thousand-dollar externality of pollution. If no one minds dirty air, conversely, no externality exists. If someone likes dirty air, this unusual person’s willingness to pay for smog must be subtracted from the rest of the population’s willingness to pay to curtail it.

Externalities are probably the argument for government intervention that economists most respect. Externalities are frequently used to justify the government’s ownership of industries with positive externalities and prohibition of products with negative externalities. Economically speaking, however, this is overkill. If laissez-faire—that is, no government intervention—provides too little education, the straightforward solution is some form of subsidy to schooling, not government production of education. Similarly, if laissez-faire provides too much cocaine, a measured response is to tax it, not ban it completely.

Especially when faced with environmental externalities, economists have almost universally objected to government regulations that mandate specific technologies (especially “best-available technology”) or business practices. These approaches make environmental cleanup much more expensive than it has to be because the cost of reducing pollution varies widely from firm to firm and from industry to industry. A more efficient solution is to issue tradable “pollution permits” that add up to the target level of emissions. Sources able to cheaply curtail their negative externalities would drastically cut back, selling their permits to less flexible polluters.

While the concept of externalities is not very controversial in economics, its application is. Defenders of free markets usually argue that externalities are manageably small; critics of free markets see externalities as widespread, even ubiquitous. The most accepted examples of activities with large externalities are probably air pollution, violent and property crimes, and national defense.

Other common candidates include health care, education, and the environment, but claims that these are externalities are much less tenable. Prevention and treatment of contagious disease has clear externalities, but most health care does not. Educated workers are more productive, but this benefit is hardly “external”; markets reward education with higher wages. The externalities of many environmentalist measures, including national parks, recycling, and conservation, are hard to discern. The people who enjoy national parks are visitors, who can easily be charged for admission. If the price of aluminum cans fails to spark recycling, that suggests that the cost of recycling—including human effort—is more than the benefit. Similarly, as long as resources are privately owned, firms balance their current profits of logging and drilling against their future profits. If an oil driller knows that the price of oil will rise sharply in ten years, he has an incentive to conserve oil instead of selling it today.

Externalities are often blamed for “market failure,” but they are also a source of government failure. Many economists who study politics decry the large negative externalities of voter ignorance. An economic illiterate who votes for protectionismhurts not just himself but also his fellow citizens . Other economists believe externalities in the budget process lead to wasteful spending. A congressman who lobbies for federal funds for his district improves his chances of reelection but hurts the financial health of the rest of the nation.

Putative externalities have been found in unlikely places. Some argue that wealth itself has an externality: inflaming envy. Others maintain that there are externalities of altruism—when I give money to help the poor, everyone else who cares about the needy is better off. Defenders of Prohibition and the war on drugs emphasize the externalities of drunkenness and drug addiction, though they typically lump private costs, such as low earnings and unemployment, in with the external costs of drunk driving and violent crime. In the Big Tobacco class action suit, one of the plaintiffs’ main arguments was that, given government’s role in medical care, smoking costs taxpayers money.

CORRECTION & SOLUTION TO EXTERNALITIES

In principle, externalities could be used to rationalize censorship, persecution of religious minorities, forced veiling of women, and even South Africa’s apartheid. If most people were to find Darwinism offensive, the logic of externalities would recommend a tax on Darwinian expression. Few economists have pursued such possibilities, probably out of a tacit sense that, in extreme cases, individual rights override economic efficiency.

Even from a strictly economic point of view, however, some externalities are not worth correcting. One reason is that many activities have positive and negative externalities that roughly cancel out. For example, mowing your lawn has the positive externality of improving the appearance of your neighborhood and the negative externality of creating a loud noise. A subsidy or a tax would alleviate one problem but amplify the other. To take a more controversial example, some economists question efforts to prevent global warming, calculating that the benefits for people in cold climates more than balance out the costs for people in warm climates.

Another economic rationale for government inaction is as follows: sometimes an externality is large at low levels of production but rapidly fades out as the quantity increases. As long as output is high enough, such externalities can be safely ignored. For example, during a famine, doubling the supply of food has large positive externalities because starvation leads to robbery, hunger riots, and even cannibalism. During times of plenty, however, doubling the food supply would probably have no noticeable effect on crime.

Yet, it is to Nobel laureate Ronald Coase that we owe the most influential argument for letting externalities solve themselves. In “The Problem of Social Cost” , Coase bypasses the earlier view that it is literally impossible to charge for some benefits. Instead, he observes that every exchange has some transactions costs, which vary from negligible—such as putting coins into a vending machine—to enormous—such as negotiating a contract with six billion signatories to improve air quality.

Coase drew strong implications from his commonsense observation. Instead of arguing about whether or not something is an “externality,” it is more productive to ask about transactions costs. If transactions costs are reasonably low, then the affected parties negotiate tolerably efficient solutions without government intervention.

To take Coase’s classic example, suppose that a railroad emits sparks on a farmer’s crops. As long as transactions costs are low, the railroad and the farmer will work out a solution. Coase was particularly clever to emphasize that, in terms of economic efficiency, it does not matter whether the law sides with the railroad or the farmer. Suppose that it costs one thousand dollars to control the sparks and the lost crops are worth two thousand dollars. Even if the law sides with the railroad, the farmer will pay the railroad to control the sparks. Alternately, suppose that it costs two thousand dollars to control the sparks, the lost crops are worth only one thousand, and the law sides with the farmer. Then the railroad pays the farmer for permission to continue sparking.

Coase’s argument was initially controversial. As George Stigler recounts in his autobiography, when Coase first presented his idea to a group of twenty-one colleagues, none agreed. After an evening’s argument, however, Coase convinced them all. Coase’s approach subsequently spread widely in both economics and law. Faced with externalities, modern analysts almost immediately inquire about transactions costs. For example, in the early 1950s, J. E. Meade advocated subsidizing apple orchards to correct for the positive externalities they provide to beekeepers. Inspired by Coase, however, Steven Cheung (1973) wrote a careful case study of the bee-apple nexus. In the real world, beekeepers and apple orchard owners do not wait for government to solve their problem. They can and do negotiate detailed contracts to deal with externalities.

Coase’s approach is probably the main reason economists are skeptical of antismoking legislation. While it is costly for smokers and nonsmokers to directly negotiate with each other, the owners of bars, restaurants, and workplaces can cheaply balance their conflicting interests. If nonsmokers are willing to pay more to avoid the smell of tobacco than smokers are willing to pay to smoke, restaurants will disallow smoking—and charge a premium for their smoke-free atmosphere. If unregulated markets fail to deliver a smoke-free world, Coasean logic suggests that smokers value smoking more than nonsmokers value not being subjected to cigarette smoke.

There are many potential solutions for market failures. Asymmetrical information is often solved by intermediaries or ratings agencies — investors rely on Moody’s and Standard & Poor’s to inform about securities risk; Underwriters Laboratories LLC performs the same task for electronics. Negative externalities, such as pollution, are solved with tort lawsuits that increase opportunity costs for the polluter. Tech companies that receive positive externalities from tech-educated graduates can subsidize computer education through scholarships.

Governments can enact legislation as a response to market failure. For example, if businesses hire too few teenagers or immigrants after a minimum wage increase, the government can create exceptions for younger or less-skilled workers. The 1978 Airline Deregulation Act solved the underproduction of cheap air travel by allowing new price and business competition. One popular public good, radio broadcasts, elegantly solved the non-excludable problem by packaging periodic paid advertisements with the free broadcast.

Governments can also impose taxes and subsidies as possible solutions. Subsidies can help encourage behavior that can result in positive externalities. Meanwhile, taxation can help cut down negative behavior. For example, placing a tax on tobacco can increase the cost of consumption, therefore making it more expensive for people to smoke.

(3) Externalities and the Free Rider Problem

Externalities can be subjective, as costs and benefits may well be viewed differently by different people. They occur in the natural course of economic activity and there is no need for any sort of governmental intervention to "correct" them. (Nor is there any certainty that the government could accomplish this).

If the actions that create the externality are actions taken in a free environment and in good faith, then the indirect benefits to others are not unjust to those that bore the cost. As long as those who bear the costs reap the benefits they wanted, their investment is a worthwhile one to them (or they would not have financed the projects in the first place). In this case, some may be reaping benefits without paying, but they are hurting no one. (It is a far worse scenario when those that are paying are not allowed to reap benefits.)

Objectivist ethics hold that rational self-interest (which may often be indirect) is the correct basis for all action. Thus these projects are financed by people who think that it is in their self-interest to finance them. If the patrons see a benefit, direct or indirect, in their funding of such projects then it is in their interests to donate to them. If they do not see a benefit then there is no valid moral reason for them to do so.

Therefore charity, or a voluntary means of payment for financing a project should invariably hold some sort of benefit for the payer himself. Voluntary payments are the only moral way to fund such projects, because forced payments can never be justified. (Force sunders the valuer from his ability to choose what to value.)

If other people are donating amply to a project that you think is beneficial, then it may be in your self-interest to not do so. As a matter of principle, most Objectivists (or even most rational people) would see it in their long term self-interests to finance such a project. But if the project is carrying on without your support, then you may want to avoid paying for it. In the logical course of events the people who would benefit most from such a project would find it in their self-interest to pay. And if no one finds it in their self-interests, then the project should probably not be undertaken to begin with.

Objective value only exists through the free exercise of an independent, rational judgment. This is true of economic value and money prices as well. The market price is nothing other than what customers are willing and able to pay and what producers are willing and able to accept. If a project lacks funding, or if a product can’t find a market, the only way to prove that it is really a “public good” with positive externalities is to demonstrate that fact through a contractual arrangement by which people agree to pay in order to have or create the benefit. To force payment without consent is not only a violation of rights, it destroys value rather than creating it.

(4) additional trade offs by public/private sector

As we make everyday choices—how much time to spend working or studying, what to spend our money on—we are experiencing what economists call trade-offs and opportunity costs. A trade-off is when we choose one option in favor of another and the opportunity cost is what is sacrificed in order to get something. Whether we realize it or not, we are constantly evaluating the costs and benefits of each decision we make; therefore, it can also be said that we are performing our own cost-benefit analysis each time we make a choice.

As decisions are made—either individually or as a society—we constantly make trade-offs in order to get more of one thing by giving up another. The saying ?time is money? illustrates this point. If we ?consume’ more free time, we are left with less money due to the fact that we are not earning money from using the time to work. The opposite is true as well; if we want more money, we must put in more work hours to get it; therefore there is less free time available. When we consider time and money, and graph the combinations for where one has no preference of one over the other, we come up with an indifference curve, such as the one below.

On the graph, X is the point where we have an even balance of time and money; yet an indifference curve is such that one is equally satisfied at any point along the curve. Therefore, we could move to point A, where we would have a lot more time but less money, or we could move to point B, with a lot more money but less time, and we would be equally satisfied. The slope of the indifference curve is based on the marginal utility of each decision; each successive move towards an axis comes at a higher price. For example, at point B we require more money for each unit of time than we do at point X because our time is more valuable since we have less of it. Therefore, we will begin to experience diminishing marginal utility.

The economy and the environment are inextricably linked. Whether we are looking at daily life or natural resources, because resources are scarce, choices have to be made about how to use them. The basic fact is that resources used to meet one choice or alternative cannot be used to meet another. Just like how we value regular goods, the valuation of natural resources and the environment is based on how we value their services and, for services that are consumed directly, that value is based on our utility and willingness to pay for a certain amount of the services.

The decision about how to allocate resources relating to the environment has an impact on all sectors of the economy, primarily because of the complex relationship between utilizing natural resources and economic output. Many times, the cost of utilizing these resources and/or services include direct costs as well as opportunity and external costs, which are not traded in markets or assessed directly in monetary terms. For example, when trees are cut for such uses as housing and furniture, some of the direct costs will include the cost of machinery and labor during cutting, processing, and manufacturing. The opportunity costs relating to this use would be the opportunities foregone by the machinery and labor that could not be used elsewhere, since it was occupied cutting trees. The external costs are the loss of environmental benefits that are no longer realized which may include a loss in watershed management services, species protection, and CO2 reduction.

Many economists and policymakers agree that in most cases the market is the best way to determine the allocation of resources. The demand for various products and the availability of natural resources—along with a number of other factors, including preferences, the number of buyers and sellers, pricing, alternative choices, etc—is expected to lead to an efficient result of actual supply and demand. However, markets can fail to account for the full cost of a natural resource and/or related services, which will prevent it from efficiently allocating the resource and lead to externalities.

To reduce the potential for market failures and their resulting externalities, planners and policymakers attempt to identify a course of action that generates the greatest societal benefits. Much of this is done by using a mix of policy and strategies, including regulation, taxes, permits, access restrictions, etc. It is finding the appropriate balance between utilizing our natural resources and meeting the demands of society that will allow us to continue to expand our economy while sustaining our natural resources and the environment.

Damages vs. Protection

social costs ; supply and demand

Negetive externalities