Externalities

The Tragedy of the Commons is a particular example of what are more generally called ‘externalities’ or ‘neighbourhood effects’. These appear whenever the costs or benefits taken into account by the participants in a transaction differ from the costs or benefits that are experienced by society as a whole as a result of the transaction.

As we saw in the previous chapter, a business will do all it can to minimise its costs, which means it will only take into account those costs that it cannot avoid paying. Trawler captains will continue to trawl as long as the money they make from selling their catch is greater than the costs they incur obtaining it. These include the salaries of their crew, the cost of mooring and running their boats and other costs such as insurance and repairs which cannot be avoided if they are to continue trawling. They do not include the wider cost to future generations incurred by depleting the fish stock below sustainable levels.

Externalities crop up all over the place. For example, walk the streets of any city these days and you cannot fail to notice the spots of spent chewing gum stuck to the pavements. What you may not realise is how difficult this gum is to remove, requiring high-pressure washing, steam cleaning or even manual scraping. In a survey conducted by London’s Westminster Council, some 300,000 pieces of gum were stuck to the pavements of Oxford Street in a period of just 10 days, while in 1990 the government estimated that local councils spent over £150 million a year removing spent chewing gum from British streets (Sample, 2007). None of these costs are born by chewing gum manufacturers so they have little incentive to come up with a solution, such as a gum that is easier to remove. Instead the cost is shared between all who pay taxes, whether we chew gum or not.

This is just one example of a much wider problem, namely the disposal of the packaging that inevitably accompanies anything we buy, from fruit to fridges. If made of cardboard then at least it can be composted, but the more usual plastic inevitably goes into our dustbins from where it ends up in landfill or is sold to places like China for recycling. The cost of its collection and disposal is not born by the manufacturer or by the retailer, but once again by the taxpayer. This might seem fairer than the chewing gum situation, as a greater proportion of us actually buy such packaged goods, but it does mean that manufacturers and retailers have little economic incentive to reduce the amount of packaging they use, or make it easier to recycle.

A rather more imaginative solution, although to a slightly different problem, is to be found in the European Parliament’s 2003 directive that is enacted in the United Kingdom as The Waste Electrical and Electronic Equipment (WEEE) Regulations 2006. This makes the manufacturer or importer of such equipment responsible for covering the cost of its eventual disposal “using the best available treatment, recovery and recycling techniques.” It is too early to judge how effective the directive will be, but putting such costs on the balance sheets of the manufacturers should encourage them to come up with equipment made from parts that are easier to re-use and less costly to destroy in a manner that does not damage our environment.

Transaction costs

Another type of externality is to be found in the costs involved in conducting the transaction itself. As Ronald Coase put it in his article The Problem of Social Cost, written in 1960:

“In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost.”  (Coase, 1960)

Take, for example, a hospital that wishes to outsource its cleaning operations. The intention is to establish an agreement with an external company to keep the hospital clean for a certain period, perhaps a year or two, after which the relationship will be reviewed and the arrangement either continued or terminated. This is quite a lengthy process. First of all the opportunity needs to be advertised so that the various cleaning companies in the market can tender for the work. Then there is a period of negotiation during which a decision is made and the final details of the contract hammered out. This will specify standards that must be reached, and how the work is evaluated. All this activity costs a great deal, possibly many thousand pounds and a considerable number of man-hours, but if the contract is worth tens or even hundreds of thousand pounds then it will have been worthwhile.

Most descriptions of the price mechanism, such as that in the previous chapter, ignore transaction costs as they have a trivial effect when buying everyday produce such as fish or eggs. They do exist – the shopper may have checked out a few shops before buying, comparing both price and quality, which takes time if not money – but in general they have little effect on the functioning of the price mechanism itself. However, as Coase suggests, there are instances where transaction costs can be so high that they stop a transaction from going ahead at all.

If a factory discharges waste into the environment then it is likely that those living near the factory will suffer in some way, perhaps experiencing greater cleaning costs or, more seriously, health problems. However any attempt to recover appropriate compensation is likely to involve the injured parties in considerable expense, particularly if the case goes to court, and there is no guarantee of a positive result. Even if they could afford the time and money involved, most people would not contemplate such an investment unless their suffering was considerable and they had some confidence of success – which is perhaps why such factories are rarely found near populations that are relatively wealthy and well educated.

For the polluter, it comes down to a balance of costs. On the one hand is the loss of sales arising from the negative publicity that such a fight would inevitably generate, and the remote possibility of having to pay a hefty settlement to the plaintiffs. On the other is the costs involved in actually eliminating the pollution, perhaps by installing expensive scrubbing equipment or moving to a more expensive but cleaner production method. Once they are satisfied that they are operating within the letter of the law, or at that it would be hard to prove otherwise, many polluters decide to do nothing. In most cases the gamble pays off, but sometimes it doesn’t.

As was common practice in the 1950s and 1960s, Pacific Gas & Electricity (PG&E) Corporation added a corrosion inhibitor called chromium-6 to the water used to cool its natural gas compressor stations in remote areas. Once used, the coolant was stored in unlined ponds at the stations from where it inevitably seeped into the ground. By the 1980s a disproportionate number of the people who lived or had lived in the small town of Hinkley in the Mojave Desert, near one of these compressor stations, were suffering a wide range of diseases, including various forms of cancer, which could be associated with chromium-6 poisoning.

Then, in 1987, PG&E took the decision to inform the State of California that they had detected levels of chromium-6 in the groundwater near Hinkley that were some ten times greater than the legal limit. The company also started talking to the residents of Hinkley in an effort to allay their fears. However PG&E hadn’t reckoned with Erin Brockovich, a file clerk working at the law firm Masry & Vititoe. In 1993, Brockovich managed to persuade 648 plaintiffs, together with her boss Ed Masry, to file a class action against PG&E for injuries caused by its actions. As the case unfolded it was revealed that an employee of PG&E had discovered levels of contamination up to 400 times the legal limit in 1965, more than two decades earlier, but the company had failed to act on the information.

In September 1994 both parties agreed to go to binding arbitration, rather than face a jury. Nearly two years later a settlement was reached requiring PG&E to clean up the effects of its pollution, stop using chromium-6 and compensate the plaintiffs to the tune of $333 million. (Brockovich, 2008) Then in 2000 the company had to see the whole sorry story publicised in the Oscar-winning film Erin Brockovich, starring Julia Roberts and Albert Finney, before finally having to fork out a further $295 million in February 2006 to resolve further claims. Meanwhile the possible consequences of similar activities carried out over the same period at other PG&E facilities near Fresno and at Topock, near the Colorado River, are still being investigated. (Lazarus, 2000)

The effect of these settlements was to bring two distinct externalities, namely the medical costs and other suffering endured by several thousand people as a result of the pollution, and the considerable legal costs incurred by their representatives in the process of negotiating the ‘transaction’ (which nearly bankrupted Masry), back onto the company’s balance sheet. The PG&E Web site now has a section on corporate responsibility which includes annual environmental reports dating from 1998. However, to put these settlement figures in perspective, the company earned over $12 billion in 2006 – primarily through the distribution of electricity and natural gas.

Education and health

So far we have concentrated on negative externalities, where the costs taken into consideration by the parties to the transaction are less than those imposed on society as a whole. As a result, the operation of the price mechanism causes the over-production of the goods or service involved. However externalities can also be positive. A positive externality occurs when the benefit derived from a transaction by society as a whole is greater than that solely received by the buyer, resulting in too little of the goods or service being produced.

Take, for example, the supermarket in a small country town which decides to build a car park out back for its customers. Those living behind the supermarket may well experience negative externalities as their views over green fields become blighted by stretches of tarmac. However those living on the streets adjacent to the supermarket will experience positive externalities as supermarket customers start parking in the new car park rather than on their streets. Other businesses in the town may also experience positive externalities as the supermarket is effectively providing parking for their customers as well, without them having to contribute anything towards its cost.

Two very important areas in which positive externalities come into play are those of education and health. It is obviously to the benefit of society as a whole, and to the functioning of the economy, if as many of us as possible are reasonably healthy. Imagine a situation where each of us is personally responsible for our individual healthcare and someone with no money catches a highly contagious disease that is very expensive to treat. If the cost of his healthcare is not quickly covered by his neighbours, then the disease will rapidly spread. The solution usually adopted is to subsidise healthcare, so ensuring that everyone has access, regardless of income. This can be achieved either by providing a healthcare service that is free to all, of which the National Health Service (NHS) in the UK is a prime example, or by distributing vouchers to those below certain income levels which can be used to pay hospital bills and the like. Both solutions need to be financed through general taxation.

The situation with education is a little more complicated. The libertarian economist Milton Friedman, who so inspired both Margaret Thatcher and Ronald Reagan in the 1980s, discussed the problem in Capitalism and Freedom, writing in 1962:

A stable and democratic society is impossible without a minimum degree of literacy and knowledge on the part of most citizens and without widespread acceptance of some common set of values. Education can contribute both. In consequence, the gain from the education of a child accrues not only to the child or to his parents but also to other members of the society. The education of my child contributes to your welfare by promoting a stable and democratic society. It is not feasible to identify the particular individuals (or families) benefited and so charge for the services rendered. There is therefore a considerable ‘neighbourhood effect’.” (Friedman, p86)

Friedman distinguished between three types of education. On the one hand is a minimum level of general schooling at primary and secondary level, teaching pupils to read and write, to interact with other people in a socially acceptable fashion, and the basics of mathematics and scientific reasoning – the basic skills, in other words, that we all need if we are to become productive members of society. Although Friedman recognised that the provision of this level of education through state-run schools is a solution, he favoured a voucher or subsidy system that would allow lower-income families to place their children in the private school of their choice.

Friedman went on to contrast higher education at college and university level with vocational and professional training. With both there is a balance between positive externalities – those benefits that extend beyond the student – and the direct benefits accruing to the students such as the higher salaries that they will be able to command once they complete the course. Anxious to ensure that those on low incomes are not excluded from such opportunities, Friedman proposed that students be offered a loan which they can use to finance such learning, repayable after graduation only once their income exceeds a pre-defined level. Strangely, given Thatcher’s affection for Friedman’s approach, it took the ‘New Labour’ government of Tony Blair to implement Friedman’s concept of student loans in the UK in 1998.

Imperfect information →