Externalities

While price control and price ceilings interfere with the functioning of the market and are often ineffective — as was the case during the Nixon administration — the government does, at times, attempt to make the markets function more effectively: namely, improve the workings of markets. Such cases are known as externalities. Positive externalities, or external benefits are cases where the benefits to society from a good or service exceed the benefits to individual consumers. 

Such goods or services would be undersupplied by the market. An often cited example is education and training. Its benefits to the consumers take the form of higher wages once they enter the labor force. But beyond that, society benefits from having an educated and informed public, hence government subsidies to education are justified to increase supply. Public goods are an extreme form of such externality. These are goods and services that are consumed collectively. They have two features: a) one person’s use of the good does not prevent others from using it, and b) it is not possible for one person to exclude another person who does not pay from using it. Examples are a public park or national defense; these have to be completely financed by the local or national government.

On the other side of the ledger, there are external costs or negative externalities. These are cases where the cost to society of producing a good or a service exceed the cost to individual firms. The prime example is environmental pollution generated in the production process. Such goods would be oversupplied by the private sector and a tax is justified to control supply. The tax would force firms to consider the negative externality as part of their production costs and would thereby lower
the oversupply. 

A proposal that created heated debate is known as a “market for pollution rights.” The Environmental Protection Agency would set a fixed limit to the amount of each pollutant allowed into the atmosphere. Combined with the demand by firms to pollute, this would set a market price for each unit of pollutant, and these can be bought and sold between firms on the market. The main outcome would be a maximum quantity of pollutants allowed, used by the firms that find pollution most useful to their production process.

Appendix: The Marginal Way of Thinking

While our column did not go into true marginal analysis, readers may encounter the concept in other contexts especially since the analysis of the firm is based on it. So, it is prudent to explain in this appendix.

It is useful to think of the firm as making marginal decisions. The term marginal is used to describe additional or incremental values. It was encountered in the context of utility derived by the consumer: “Marginal satisfaction” is the incremental satisfaction obtained from consuming an additional unit of the product. And it applies equally to positive or negative increments — an added or a subtracted unit.

Knowing or not, we all make marginal decisions in our daily lives. A student enrolled in four courses and considering taking a fifth asks herself, “What are the extra (marginal) costs, in time and money, of taking the fifth course, and how do they compare to the extra (marginal) benefits from the course, in terms of knowledge gained or graduation requirements?” Only if the marginal benefits exceed the marginal cost would she sign up for the fifth course. A comparison between the marginal costs and the marginal benefits is inherent in such a decision.

Our Daily life is full of marginal decisions, or decisions at the margin. And these determinations operate in reverse. Should the student drop one of her five courses? She makes the decision by comparing the marginal saving in time and money with the marginal loss of benefits in terms of knowledge, information or progress toward a degree. Only if the marginal savings exceed the marginal loss would she proceed with the cut. 

In a similar way, the firm makes marginal decisions. Starting from a certain scale of operations, the firm may ask, “Should I hire one additional (marginal) worker? Such a decision involves incremental costs of paying for the new worker; but it yields additional revenue from selling the extra product. The firm would proceed only if the added revenue from the added output exceeded the added cost of the worker. Alternatively, the firm may ask the question in reverse, “Should I lay off one of my workers and allow an output-drop?” In doing so, it would save the wages of one worker, but would also lose the proceeds from the sales. Only if the marginal savings exceed the marginal loss (from reduced sales) would she proceed with the cut.

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Mordechai E. Kreinin

Mordechai E. Kreinin

Mordechai Kreinin is a University Distinguished Professor of Economics, emeritus at Michigan State University and past President of the International Trade and Finance Association. He is the author of about 200 articles and books about economics, including the widely used text, International Economics. He can be reached at kreinin@msu.edu or by cell phone at (517) 488-4837

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