Terms Beginning With 'e'

Externality

  • November 11, 2020
  • Team Kalkine

What is meant by an externality?

An externality is a cost or a benefit associated with an economic activity that affects a third party not related to the activity. Externalities can be positive or negative, depending on the impact they have on the receiver. Negative externalities can be extremely harmful to not just a firm, but for the society at large.

The receiver of an externality can include any firm other than the one causing it, or individuals. It can also be incurred as a welfare loss or received as a benefit to society. The cost or benefits may be financial and can end up reducing a firm’s revenue in case of a negative externality.

What causes externalities?

One of the leading causes of externalities are poorly defined property rights. Some intangible goods are hard to account for and given ownership of. These include intellectual property, pollution, climate change, research & development activities and so on.

All these externalities cannot be quantified and segregated based on ownership. For instance, pollution caused in a city can not be differentiated based on the firms causing it. Thus, it becomes difficult to measure them and associate them with individual firms.

Similarly, it may not be possible to find out who are the receivers of an externality. Taking the same example of pollution, one can see that it is practically impossible to measure the ill-effects of pollution caused to every individual in a city. Even if the firms causing an externality were to compensate the receivers, it would be far too challenging to find out who the receivers are and how much compensation should be offered to them.

This is also a significant reason why the inequitable distribution of resources occurs. For instance, a firm dumping factory waste into a river may not realise that the river is the primary source of sustenance for the people of that area. However, it is possible that the same firm might be fulfilling its water requirements from other cleaner water bodies.

How are negative and positive externalities differentiated?

  • Negative Externality: When the actions of a firm or an individual incur a cost to a third party. An example of this can be the felling of trees by a firm which can lead to climate change. A negative externality can be observed on an individual level too. For instance, when an individual decides to play loud music, it may cause harm to the neighbours.

They are caused when the Marginal Social Costs outweigh the Marginal Private Costs. This means that the cost incurred by the entire society is more than the cost incurred by an individual firm. Consider the following diagram:

Here, the free market output is determined by the firms individually at the intersection of market demand (MSB Curve) and the market supply (MPC). However, the cost to society is higher than the cost to the firm. This is the reason why the MSC curve lies higher than the MPC curve.

The free market output is higher than the socially optimal output. This implies that there is overproduction in the economy. Here, triangle OAB represents deadweight loss, which is a cost to society.

Example of negative externalities can be the damage to society due to the pollution caused by a firm, health conditions liked to passive smoking, health hazards to individuals caused by pesticides and non-organic farming.

  • Positive Externality: Any action caused by a firm or an individual that benefits a third party can be considered a positive externality.

An example of this can be the transfer of intellectual property from one firm to another. For instance, when an individual changes jobs, he may transfer the knowledge gained from his previous employer to the new firm. This means that the new firm did not pay the employee for this extra information, nor did they conduct R&D operations to find out this information, but the firm still receives this additional benefit.

Other examples of a positive externality would include education, the cost for which is incurred by an individual, but the educated masses of the society enjoy the benefits. An educated workforce is an asset to the entire society and not just to the individuals themselves.

Consider the following diagram:

Here, Private Social Cost exceeds the Marginal Social Cost. In simple terms, this means that the firm is paying for the betterment of the society overall. Here, the Free market output is less than the socially optimal level of output, unlike the case of negative externality. Hence, there is underproduction in the society.

What are the implications of externalities?

Externalities lead to market failures because they deviate the production from the socially optimal levels. Both positive and negative externalities lead to output levels which are not optimal. Positive externalities lead to lower production of goods than the socially optimal level, while negative externalities lead to higher production of goods than the socially optimal levels.

Negative externalities have more severe impacts than positive externalities. They are more common than positive externalities too. They lead to a loss of welfare in the society.

Generally, negative externalities are pareto inefficient. While positive externalities are a type of market failure, they are still pareto efficient as they cause overall benefit to the society. Thus, positive externalities are not as disruptive as negative externalities.

How to resolve externalities?

Externalities can be overcome when they are internalised into a business. This can be achieved through appropriate government policies that would curb the spilling over of these effects onto third parties. Some of these measures include:

  1. Taxation: Goods that have a negative externality attached to them can be taxed to reduce their consumption. For instance, cigarettes can be taxed so that their consumption is lessened. Similarly, for producers, an appropriate tax can be put on activities that are known to cause damage to the environment.
  2. Subsidies: Firms can be encouraged to go for production activities that are less harmful to the society by giving them a subsidy for those activities. For instance, the government can give subsidies on solar panels for businesses who wish to adopt alternative forms of energy creation. Similarly, government can provide subsidies to produce those goods which have a positive externality attached to them.
  3. Defining Property Rights: Lack of defined ownership can cause externalities. For instance, the knowledge spillover from one firm to the other is caused because the intellectual property rights of the firm that has invested in R&D are not secured. However, this task becomes difficult when property rights are to be assigned to natural resources like air or water.

What is Pigouvian tax? Pigouvian tax (also written as Pigovian tax) refers to the tax imposed on those economic activities that lead to a negative externality in the economy. These economic externalities lead to costs which are borne by third parties. A Pigouvian tax reverses the market inefficiency caused by an externality by increasing the market prices. When the actions of a firm or an individual lead to a cost that is incurred by a third party then it is called a negative externality. An example of this can be the dumping of factory waste by a firm into a river that is a necessary means of survival for the individuals situated near the river. A Pigouvian tax increases the marginal private cost by an amount equal to the negative externality. Thus, the final cost of such a good would be equal to the full social cost of the production of the good. This leads to the internalisation of a negative externality. Who introduced Pigouvian tax? The theory of Pigouvian tax was given by British economist Arthur Pigou. In his book “The Economies of Welfare” published in 1920, Pigou explained how economics can be used to improve the lives of the poor and needy. He asserted that adopting preventive measures during the production process could make the markets a lot more efficient. Pigou maintained that the classical ideology of an invisible hand guiding the economy towards the optimal equilibrium was false. Instead, he believed in firm government action to prevent externalities. This included “bounties and taxes”. For instance, Pigou pointed out that the producers and sellers of intoxicants were not associated with the costs required to fund policemen and other law regulators. These policemen would, in turn, be responsible for managing individuals who had been under the influence of these intoxicants. The idea of externalities was first given by Alfred Marshall, a British economist. But Pigou, being his student, extended the idea and finally popularised the theory of a tax to increase efficiency in market. How does a Pigouvian tax work? To understand the above diagram, following full forms are necessary: SMC = Social Marginal Cost, which refers to the cost of the production of a single unit of the good, incurred by the entire society PMC = Private Marginal Cost, which refers to the cost incurred by the firm to produce a single unit of the good. PMB = Private Marginal Benefit, which refers to the benefits enjoyed by the consumers on the consumption of a single unit of the good. It is the highest amount a consumer will pay for a single unit of a good. SMB = Social Marginal Benefit, which refers to the benefit enjoyed by the entire society on the consumption of a good. Point A = Free Market Equilibrium. Point B = Socially Efficient Equilibrium Free market condition refers to the economic state where the externality establishes itself because of the unregulated actions of a firm. Firms operate with the intent of maximising profit and do not internalise the negative externality. Thus, the Social Marginal Benefit (SMB), which represents the demand in the economy, is equal to the Private Marginal Cost, which is the firm’s supply. The Private Marginal Cost is less than the Social Marginal Cost. Thus, firms can produce more than the socially optimal level of production. The social marginal cost is greater because the actions of the firm lead to a cost to the society which may come in the form of increased pollution, health-related issues because of passive smoking and the usage of chemicals in farming. The value of the tax should be equal to the value of the damage caused by the firm’s production activities. The tax increases the production cost of the firm. This cost is passed down to the consumers in the form of increased prices. This reduces the demand, and therefore, the quantity produced would decline. This would lead to the socially optimal quantity being achieved. How is Pigouvian tax beneficial to the society? Pigouvian tax helps achieve a socially optimal level of production in the economy. In the case of a negative externality there is overproduction in the economy. Firms produce more than the socially optimal level due to the cheaper cost of production. It also helps discourage behaviours that would lead to a negative externality in the economy. For firms that cannot avoid overproduction, a Pigouvian tax helps raise the revenue to reduce the externality caused by the production process. How is Pigouvian tax disadvantageous to the society? The externality of a production process can be hard to measure especially when it is measured in terms of aspects like environmental pollution. Thus, it becomes difficult to determine the amount of tax, which should ideally be equal to the amount of externality. A flat Pigouvian tax can be considered a regressive tax as it ends up hurting the lower income groups more than it affects the higher income groups. Thus, this type of a Pigouvian tax would be regressive in nature. In addition, if the tax is not implemented correctly then it can further cause higher inequality in the economy and make the tax more regressive. If the government offers too many exemptions to companies, then the burden of the tax would fall on only a few companies. Therefore, the implementation of the tax should be fair and correct.

What is greenwashing? Greenwashing is the act of projecting the products of a company as being environmentally conscious when they are not so in reality. Companies use greenwashing to attract customers who prefer products that do not cause any environmental damage. They make false claims about how their products do not cause harm to the ecosystem and are sustainable. Firms would usually spend a lot of time and money advertising themselves as an environmentally conscious brand. However, in reality, the firm does not spend that much amount in producing environmentally-conscious goods and removing negative externalities like pollution and ecological destruction coming from their business. Why do companies greenwash their products?  As consumers are becoming more aware of the ill effects of consumer goods on the environment, they are moving towards environmentally conscious products. Many producers seek to take advantage of this by giving a false sense of satisfaction to consumers about the benefits of their products. This allows firms to overproduce than what the socially optimal level of production is in the economy. When the consumer demand shifted to environmentally friendly products, the producers realised that they would not be able to sell those products which are cheaper to produce and are not environmentally friendly. Instead of looking for safer options, they decided to exploit the current production process by marketing it as environmentally friendly to bring a positive sentiment in the market about the company. Specific greener alternatives for production might be costlier for companies as they require permits from the government, more expensive equipment like solar panels or costlier inputs to work with. Thus, companies abandon these alternatives by investing money solely in branding and advertising rather than going for these greener substitutes. How did the term greenwashing come into existence? The term ‘greenwashing’ was coined in the year 1986 by environmentalist Jay Westerveld. The ideology leading towards greenwashing started when Jay Westerveld saw a note by a resort on a beach asking the customers to pick up their towels on their own. The note urged consumers to help the resort save the environment by picking up towels and reusing them. However, at the same time, the resort chain was expanding and was commercialising even more. This was not perceived as a very environmentally conscious move. Thus, Westerveld believed that the resort was showing false concerns about the ocean and about the conservation of the coral reefs. This later progressed to more obvious forms of greenwashing when Westinghouse nuclear plants claimed that they could produce cheaper electricity than other coal plants with far less environmental damage. These marketing strategies came long after the nuclear blasts happened across the globe. By that time, people were aware of the impacts of nuclear energy and a large amount of nuclear waste that it comes with. What are the methods used by companies to greenwash their products? TerraChoice, an environmental marketing agency, has given the seven sins of greenwashing which are used to screen various marketing campaigns by companies. These include: No Proof: These are the claims made by companies without any backing whatsoever. Companies may use this to make claims about the inputs used or about certain methods used in production, which cannot be fact-checked easily. Vagueness: Companies may use taglines that are not specific and may mislead the consumer. For instance, not providing details about how the product reduces pollution contributes to the vagueness surrounding such claims. False Labels: Companies may sometimes use certifications that they have manufactured. This is done to give satisfaction to the consumers that concerned authorities have tested their products.  Hidden Trade off: This involves hiding the important ecological concerns under the umbrella of a small benefit that has been exaggerated to seem too important. For instance, marketing a car model as being highly fuel-efficient; however, the same car is produced in a factory that releases excessive smoke and dumps waste in the water. Irrelevance: This refers to the emphasis given to issues that are not of much importance. For instance, highlighting an initiative taken by the company which might not even have contributed to reducing the pollution caused by it. Lesser of two evils: Providing claims on products that do not have any environmental benefits arising out of them. False Claims: This is done by promoting the products based on claims that are obvious lies. These lies are published with certainty even when they are blatantly false. Kalkine Group Image Why is it important to avoid greenwashing? Companies need not project themselves as completely green organisations. They should maintain a certain degree of transparency with respect to the environmental benefits of using their products. Giving a falsely glorified image about the environmental consciousness of a company can lead to overproduction in the economy. When companies provide legitimate information, they may be taxed for causing environmental damage which is bound to happen up to an extent. However, making false claims and providing no proof over certain benefits may never allow for optimal welfare to be achieved in the economy. When companies greenwash their products, it defeats various movements and initiatives taken across the globe to ensure that ecological sustainability is maintained. Therefore, companies must invest more in actually adopting greener initiatives rather than just marketing themselves as greener companies.

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