External effects in the economy - this is the effect of one person on the well-being of another. This is an interesting section, which not only explores new formats of relations between enterprises and consumers, but also regulates problems arising from a lack of public goods and resources.
How it all started
Sometimes the market stops working as expected, and so-called failures arise in it. Often, the market model cannot cope with such phenomena on its own. And then the state has to intervene to restore balance.
The thing is that people use the same resources: peace and land cannot be divided into sections of private space. The actions of one person can damage another person without the presence of any malicious intent. Speaking in the language of economists, a positive factor in the form of consumption or production of one can lead to a negative impact on the consumption or production of another.
These effects are the causes of market failures. They are called external effects, or externalities.
Definition of external effects and their types
There are many formulations of external effects. The shortest and most intelligible of them is as follows: external effects in the economy are gains or losses from market transactions that were not taken into account and as a result were not reflected in the price. Most often, such things are observed when consuming or producing goods.
Goodness is all that benefits and gives pleasure to man. If we keep in mind economic benefits, then these are desirable but limited in quantity goods and services.
Positive and negative external effects in the economy differ in the nature of the impact on the subject: negative effects lead to a decrease in the usefulness of any consumer or products of any company. Positive, on the contrary, to increase utility.
The classification of the types of external effects in the economy is determined by several criteria, one of them - by the type of influence on the subject:
- technological (as a result of economic activity that does not fall under market processes);
- cash (expressed in changes in the value of factors of production).
Effects by the level of influence on the subject:
- marginal;
- intra-marginal.
By the method of transformation or elimination:
- external effects that only the state can handle;
- effects that are neutralized through negotiations between the recipient of the external effect and the producer.
Four directions of action of external effects
1. Production - production
An example of a negative effect: a large chemical plant discharges waste into a river. The downstream bottled beer factory has sued because of the damage inflicted on the processing technology of the brewing equipment.
A positive effect is the mutual benefit of the bee apiary and fruit farming located in the neighborhood (a direct relationship between the amount of honey collected and the number of fruit trees).
2. Production - the consumer
A negative example: harmful emissions into the atmosphere from the pipes of a local plant reduce the quality of life of urban residents. And with the same alignment of forces, there was a positive effect: the repair of railway access roads and the underground passage from the station to the factory passage brought the residents of neighboring areas the benefit of convenient transportation and cleanliness in the city.
3. Consumer - production
Negative impact: numerous family outings cause enormous damage to forestry due to forest fires. Positive effect: the emergence of volunteer organizations to maintain cleanliness in the environment led to systematic cleaning and cleanliness in city parks.
4. Consumer - consumer
Negative effect: the classic showdown of neighbors due to the loud music of one of them in the late evenings. The quality of life of other “listeners” is sharply declining. Positive impact: a flower lover breaks a flower garden under the windows of a multi-storey building every spring. For neighbors - continuous positive emotions of visual origin.
Positive externalities in the economy
We will deal with the “increase in utility”, which is expressed in growth and is regarded as the external benefit of any type of activity.
A large enterprise that built access roads and high-quality highways within the city for its production needs has benefited the residents of this city: they also use these roads.
Another example of positive external effects in the economy is a fairly common situation with the restoration of historic buildings in the city. From the point of view of most citizens, this is a pleasure of beauty and architectural harmony, which is an absolutely positive factor. From the point of view of the owners of such old buildings, the restoration process will bring only serious costs and no benefits. In such situations, the city authorities often take the initiative, providing tax incentives or other support to the owners of dilapidated buildings or, conversely, setting obstacles to their demolition.
Negative external effects in the economy
Unfortunately, negative effects are more common in real life. If the activity of one subject negatively affects the activity of another, this is an external effect in the economy with a negative effect. Numerous examples are cases of environmental pollution by industrial enterprises - from dispersed particles in the air to polluted water in rivers and oceans.
A huge number of court hearings are held in the world over the increase in the incidence of people due to reduced water quality, dirty air or chemical clogging of the soil. Cleaning equipment, as well as all other actions to minimize pollution of any kind, are expensive. These are serious costs for manufacturers.
An example of negative external effects in the economy is a case with a paper mill that uses clean water in a neighboring river using production technology. The factory does not buy this water and pays nothing for it. But it makes it impossible for other consumers to use river water - fishermen and bathers. Pure water has become a limited resource. The factory does not take into account external costs, it operates in a Pareto-inefficient format.
Coase's theorem: the problem can be solved
Ronald Coase - Nobel laureate in economics, author of the famous theorem under his own name.
The meaning of the theorem is as follows: private and public costs are always equal, regardless of the distribution of property rights between economic entities. According to Coase's research and the main points of his theory, the problem of external effects can be solved. The solution is to expand or form additional property rights. We are talking about the privatization of resources and the exchange of property rights to these resources. Then the external effects will turn into internal ones. And internal conflicts are easily resolved through negotiations.
It is easiest to understand the theorem using real examples, of which there are many today.
Adjusting externalities: adjusting taxes and subsidies
Coase’s theorem reveals two ways to control the positive and negative external effects in the economy:
- Adjusting taxes and subsidies.
- Privatization of resources.
A corrective tax is a tax on the release of goods with a negative external impact to increase marginal private costs to the level of marginal social costs.
A corrective subsidy is issued in cases of a positive external effect. Its purpose is also the maximum approximation of marginal private benefits to ultimately social ones.
Both taxes and subsidies aim to redistribute resources to increase their efficiency.
Privatization of resources
This is the second approach from Ronald Coase, which consists in the privatization of resources in the form of an exchange of property rights to them. In this case, external effects will change the status and are modified into internal ones, which are much easier to solve.
There is another way to solve the problems of external effects: persuade to cover all the costs of who is the source of the external effect. If this succeeds, the producer of external costs will begin to optimize the balance of benefits and costs, and this situation is called Pareto efficiency.
If payment of the received positive effect is impossible or inexpedient, then this benefit turns into a public one - the ownership right changes. It becomes a purely public good with two properties:
“Non-selectivity”: the consumption of good by one entity does not exclude its consumption by other entities. An example is the traffic police regulator, whose services are used by drivers of all cars passing by.
“Inclusiveness”: if people refuse to pay, you cannot forbid them to use the public good. An example is the state’s defense system, which has two of the above properties at once.
Life examples
- Emissions from car engines are external effects in the economy with a negative effect in the form of poisonous air that many millions of people breathe. Government intervention is an attempt to reduce the number of cars through the introduction of a gas tax and strict regulations on car exhausts.
- An excellent example of a positive external effect is the development of new technologies, and with them the emergence of a whole layer of new knowledge that society uses. No one pays for this knowledge. Authors and inventors of new technologies cannot receive funds from the benefits that the whole society receives. Research resources are declining. The state solves this problem in the form of payment of patents to scientists, redistributing, thus, the ownership of resources.
Internalization of external effects: marry a neighbor
We have already mentioned the transformation of external effects into internal ones. This process is called internalization. And the most popular way is to unite entities associated with an external effect into a united common person.
For example, you are mortally tired of a neighbor with her loud music with low frequencies in the late evenings. But if you marry this neighbor and unite in one person, a decrease in the usefulness of this effect will be perceived by the whole family as a general decrease in the usefulness of the effect.
And if the chemical production and brewing company mentioned above merge under the umbrella of a common owner, the external effect in the form of water pollution disappears, because the costs of reducing beer production will now be covered by the same company. So water pollution will now be minimized as much as possible.
