Economics Lecture Ten
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Tenth Lecture – Review and Externalities
Instructor, Andy Schlafly
Contents |
Externalities
“Externalities” are benefits or costs that are external to the seller and buyer of a good or service, for which no compensation is made. That may puzzle you at first. A company produces a good at its expense, and sells to a buyer who pays for it. The buyer bore the cost and received the benefit of the good itself. The seller bore the cost of producing the good, and received the payment for selling it. What else could be going on here?
After all, when you buy gas, you pay the cost and you receive the benefit. It’s a transaction between you and the service station. What cost or benefit does anyone else receive?
Next time you’re traveling in a car, take a look at the exhaust pipe on the car in front of you. Pollution comes out of it. The pollution used to be far greater than it is today, but there still is some exhaust. In some neighborhoods, it’s fashionable for car owners to modify their cars so that the engines consume less gas by producing more pollution. You can smell the difference when you are stuck behind one of those cars. Airport taxicabs are notorious for putting out more pollution than the average car. Airplanes themselves put out substantial pollution at airports as they idle.
The driver of a car or airplane does not bear all of the cost of the fuel. The public is bearing the cost of the pollution. Some people who never drive cars or fly in airplanes bear the cost of the pollution. This is an called a “negative externality” because it imposes costs on people who did not buy the good.
Car pollution is often unnoticeable. But sometimes pollution can be severe and dangerous. If a company can dump its waste into a river for free, then it is economically profitable for it do so. Those who like to swim or fish in the river will suffer the expense. Either they will have to curtail their activity, interfering with their utility, or they could become sick from it.
There are “positive externalities” also. These create benefits for the public without requiring some to pay for it. If you happen to live next to an outdoor concert facility, then you may enjoy listening to music without buying an admission ticket. The people paying for the concert receive the benefit they want, but you would receive a benefit free to you as a “positive externality.”
A “public good” is something, like music, that provides a benefit to one person without reducing the benefit to others. One listener does not lose benefit by the presence of other listeners. Food, in contrast, is not a public good.
Can you think of other positive externalities? Public transportation, perhaps, where the price of a ticket is less than the true cost? The New York Subway system, where you can go anywhere in all of New York City for a mere $1.50? How about free internet music through peer-to-peer networks like the old Napster?
The internet is filled with activities that create both positive and negative externalities. The positive externality is all the free and useful information posted on websites at someone else’s expense, but available to the public. The negative externality is all the pornography that destroys those who fall victim to it, creating costs for society to bear in dealing with them. FBI agents say that the one common attribute of every criminal residence that they raid is the presence of pornography.
Professor Lawrence Lessig is a champion of the “commons” on the internet. The “commons” is a term from medieval England, when anyone could bring their sheep to graze on public land. Ultimately, all the grass was eaten and then the commons was not of much use, so the story goes. Professor Lessig supports free books, music, etc., over the internet. He took a case to the U.S. Supreme Court fighting long copyright extensions (Eldred v. Ashcroft). In the end, some Justices seemed worried about the impact on private property of his theories, and he lost.
Illegal drugs create perhaps the largest negative externality. The transaction is between the drug dealer and the drug addict, but when that drug addict runs out of money due to his habit then he is going to turn to crime. Soon he will be robbing and even killing people to obtain money to feed his addiction. The victims of this crime bear the negative externality.
What is the cause of positive and negative externalities? It is desirable to eliminate the negative externalities, so that sellers bear all the costs of their production and sales. How can they be required to pay all of their costs, rather than pushing those costs onto the public?
Taxes are the typical way. Government imposes a gasoline tax, supposedly to pay for the costs imposed on society by cars. For positive externalities, government subsidies are a way to make the public to pay for benefits that it receives, and support the firm providing the benefit.
The problem is, politicians are known to maximize their own interests in setting tax policy rather than maximizing public interests. “Public choice theory” recognizes that self-interested politicians can act contrary to public interest.
Remember Ronald Coase? He would say that the reason for externalities is transaction costs. If it were practical to give everyone a right to be free from pollution, and then allow them to sell it without incurring transaction costs, then the negative externality of pollution would disappear. People would accept small payments from Exxon and other oil companies in exchange for allowing the gas to add a little pollution to their lives, if transaction costs weren’t larger than the payments. We would not need additional taxes on gasoline by an inefficient government.
Antitrust Laws
The response of government to externalities and to the very different problem of monopolies is regulation. Regulate the polluters; police the trading of music over the internet; and break up the monopolies like Standard Oil, AT&T, and perhaps Microsoft (which barely avoided a break-up by the skin of its teeth!).
Negative externalities and monopolies become popular targets for politicians from time to time. Democrats campaign on a platform of increasing regulation to protect the environment against big business. “Don’t let companies pollute your lake and streams,” environmentalists say. A hundred years ago, President Teddy Roosevelt broke up big monopolies and cartels and became immensely popular for it.
There are more poor consumers who vote than wealthy businessmen, and many politicians think the road to election is paved with appeals to consumer interests. As long ago as 1890, the Sherman Antitrust Act was passed to prohibit combinations, trusts and conspiracies that restrict trade and prohibit cartels. The Clayton Act of 1914 went further and even prohibited price discrimination if not justified by cost differences. Accordingly, the term “price discrimination” is rarely used by businesses, because it sets off alarm bells of illegality. But in practice, virtually every business does engage in price discrimination in some form.
Sometimes the pendulum swings the other way. Ronald Reagan became president by ridiculing the vast amounts of regulation of free enterprise. “Get the government off the back” of businesses and the people. He sought “less government.” He would tell stories of senseless regulations, like one requiring American Indians working on high bridges to wear life-preservers in case they fell. First of all, the life-preservers were unbearably hot and of doubtful value even to those who fall. Second of all, the regulations applied even when there was no water below!
In the free market, change is nearly instantaneous to new developments. When a company announces it is bankrupt, it’s stock value drops to near $0 within minutes. However, it can take the government months or years to adjust to a new development. Louis Freeh, director of the FBI for eight years, was so far behind technologically that FBI agents had to use their more advanced personal computers at home in order to exchange large files!
An additional problem with regulations has arisen in the past ten or twenty years. Big businesses have learned how to influence regulators by holding out the possibility of hiring them. Fifty years ago, large companies had policies against hiring those who regulated them. But today, “regulatory capture” is pervasive. Regulators curry favor with the companies they regulate in order to obtain jobs at twice their government salary. The regulators end up helping the large companies at the expense of smaller companies and the public. The regulators have been effectively “captured” by big companies. The fox ends up guarding the chicken coop.
Finally, imagine a regulator imposing price controls on a natural monopoly. Forcing P = MC for a natural monopoly, however, would require a subsidy by the government if ATC > P. Without a subsidy, the company shuts down. Alternatively, if regulators set P = ATC for the natural monopoly, it does not need a subsidy but it is not producing an optimal output Q. Government price controls are almost never desired from an economic perspective. However, they may be popular politically.
Adversity and Suffering
Some concepts in economics are surprising, as as some teachings of Christianity are surprising the first time. An example is that difficulties can actually be blessings. Consider how a tree grows.
A tree starts out as a tiny seed with apparently little chance of survival. It must find nourishment deep in the soil, and it must defy gravity by growing towards the sky for sunlight. Typically no humans help it. The tree has to make it on its own, and deal with tornadoes, hurricanes, and hostile animals. The tree never “owns” anything.
Tree limbs are very heavy, to the point of crushing houses or killing people when they do fall. The tree has to raise and support its heavy limbs against gravity. The flow of a tree’s nutrients is also against gravity. Trees grow in unexpected places, and sometimes around pre-existing obstacles. Out West roads have even been cut through trees, and they still survive and thrive.
Yet the difficulties in surviving are what make a tree strong. Each day it grows in two directions: downward further into the soil towards more nutrients, and upwards into the sky towards more sunlight. Its growth is not easy in either direction. The more it has to reach for nourishment, the bigger and stronger it becomes. Trees that are given their nutrients, as in a laboratory, do not grow as large and powerful as trees that must struggle to survive in the wild.
It is in striving against obstacles that the tree becomes so powerful. Economics predicts that those who suffer from adversity will often become more successful or productive than those who have it easy, just as is true for trees. The adversity is what makes one stronger, more motivated and more efficient. Many of the most successful businessmen in history had very difficult childhoods, and some (like Tom Monahan, founder of Dominos Pizza) even grew up in orphanages. Poverty was the common background of most successful businessmen. In contrast, people who have had it easy rarely invent or succeed with their own businesses.
The Bible contains a similar message: it is through suffering and difficulties that Christianity became so strong. Many books in the Bible emphasize this, from Daniel to Mark. Learn to use adversity like an exercise bicycle or weights in order to make you stronger and more successful economically.
There is a Latin phrase: "nitor in adversum." It means "strive in opposition." It's a good motto.
ASSIGNMENT
Make a list of the concepts at your level in the list at the beginning of this lecture. Divide your list into two categories: concepts you understand, and concepts you do not understand. Try to shorten the list of concepts you do not understand by reviewing the lectures. Then hand in your final (shortened) lists next week.
