(6) Externalities

(A) Free-riders ruin everything

A constant theme in economics is the assertion that trade makes everyone better off. So long as the trade is voluntary, both buyers and sellers are better off from the trade. There are times, however, when a trade impacts a third party, resulting in something we call externalities. Unless we know how this third party is impacted we cannot say whether the trade makes everyone better off.

Definition of externality

An externality occurs when an exchange between a buyer and seller impacts a third-party who was not part of the negotiation.
A negative externality occurs when a trade between a buyer and seller harms a third-party, and that third-party was not part of the negotiation.
A positive externality occurs when a trade between a buyer and seller benefits a third-party, and that third-party was not part of the negotiation.

Suppose Tyson Foods sells chickens to the residents of Oklahoma. If chicken production impacted only the company and consumers then we know that the market for chicken would be beneficial overall. But what if the manure from the chicken farms enter rivers, causing pollution which not only taints a town's water supply but also curtails fishing and swimming? Now it is unclear whether that chicken production is good or bad, overall, for society. Now, we need to investigate the extent of pollution to determine if it is worth addressing, and if it is, the best plan of attack. That seems to be the current situation of chicken production in eastern OK, as suggested by scenes from the documentary A River of Waste below.

Video 1—Negative Externalities in Eastern Oklahoma (from documentary, A River of Waste)

Nobody likes free-riders—people who benefit at the expense of others, and externalities occur when free-riding take place. If A River of Waste is correct then chicken producers and consumers are benefiting at the expense of water users, without those users' consent. Chickens producers are free-riding off of other people.

There are times when positive externalities occur. In this case people experience benefits that are paid for by others. The clip below shows two ladies benefiting from a workout without paying for it. They free-rider off all the others who paid the exercise instructor. Perhaps the best illustration of a positive externality is immunization against disease. If you pay for a vaccination against the flu virus you not only improve your health, but because you are less likely to get the flu and pass it to others, other people benefit off your vaccination.

Every positive externality can be framed as a negative externality, and vice-versa. Just as vaccinating your child creates a positive externality by reducing the spread of disease to others, not vaccinating your child creates a negative externality by increasing the spread of disease to others. Because of this correspondence I will simply use the term “externality” and frame it in terms of a negative.

Video 2—Illustration of Free-Riders (from movie, Bridesmaids)

(B) Externalities are nothing new

A train passed over the Cuyahoga River on June 22, 1969. It was not uncommon for sparks to fly from the friction of train wheels on the track, but usually the train is passing over treated wood, rocks, or water, and will not catch fire. On this day, it passed over a river so polluted it actually caught fire!

Figure 1—Ohio River Polluted So Bad It Caught On Fire

What is even more surprising is that this was not the first time it happened. There was 1868, 1883, 1912, 1922, 1936, 1941, 1948, 1952, and now 1969! Cleveland had been known as a town where businesses could pollute. Steel mills especially dumped waste right into the river with no monitoring, no accountability, and no regulation at all. One government official remarked about the river in 1969, "The lower Cuyahoga has no visible signs of life, not even low forms such as leeches and sludge worms that usually thrive on wastes."

Quotation 1—The wit of a Native American

   Every now and then I am impressed with the thinking of the non-Indian. I was in Cleveland last year and got to talking with a non-Indian about American history. He said that he was really sorry about what had happened to Indians, but that there was a good reason for it. The continent had to be developed and he felt that Indians had stood in the way and thus had to be removed. "After all," he remarked, "What did you do with the land when you had it?"
   After reviewing the argument of my non-Indian friend I decided that he was probably correct. Whites had made better use of the land. How many Indians could have thought of creating an flammable river?
—Deloria, Vine Jr. 1970. We Talk, You Listen: New Tribes, New Turf. University of Nebraska Press: Lincoln, NE.

This fire in 1969 was different though, because in just thirty minutes it did considerable economic damage. The devastation made people realize that there was little concerned citizens could do to prevent the businesses from polluting. The government needed more power to protect the environment. In response, a Republic president (Nixon) proposed creating the U.S. Environmental Protection Agency, and it was later approved by Congress in 1970.

I guess we should just say we are thankful events like this are only in the past. Except they aren’t. Now, more important things are catching on fire!

Figure 2—Page 135 of Colbert’s America Again

Suppose you are a fan of Stephen Colbert who bought his book, America Again, and you also live near a fracking sight. On page 135 of Colbert's book is a picture of a dragon head with instructions to cut a hole in its mouth and mount the head on your sink faucet, allowing your faucet to become a SA-WEEEET dragon. What ever was he referring to? Watch the following video and find out.

Video 3—Colbert on Fracking
(A farce about conservative's view on environmental issues)

(C) Pollution isn't just a "capitalism thing"

It is common to hear externalities being used as an argument against capitalism, or free trade, or free-enterprise, or whatever you call democratic economic systems where property and the right to an honest-profit is protected. It is true that in America and western Europe there are companies able to profit by externalizing their pollution and other costs onto society, but pollution is arguably far worse in totalitarian / socialist / communist economic systems, because in these countries people who are harmed have no mechanism for being compensated or for punishing the polluter.

Video 4—The documentary The Corporation explains externalities

In a democracy you can also pressure politicians to protect you from polluters, but in communist China, the politicians were the polluters, so the average person was helpless.

Quotation 2—Mass pollution in communist China (1950-1970)

   China had no treatment plants, and both urban sewage and industrial waste were discharged directly into local rivers. In the drive to transform a predominantly agricultural society into an industrial powerhouse capable of leading the socialist camp in its conquest of the world, the amount of pollutants such as phenol, cyanide, arsenic, fluorides, nitrates and sulphates released into the water streams surged.
   So great was the amount of alkaline waste released by paper mills in Jiamusi that even the bottoms of boats corroded. The mills themselves were no longer able to produce high-quality paper because they relied on the river water they so heavily polluted. This was the case for all factories in the belt stretching from Shanghai down to Hangzhou. Oil companies were also culprits, a single plant in Maoming releasing a 24,000 tonnes of kerosene into rivers each year.
—Dikotter, Frank. 2010. Mao's Great Famine. Pages 184-185. Walker & Company: NY, NY.

(D) Confronting the negative externality problem

Externalities result from a free-rider problem, so they can be confronted by eliminating free-riders. There are many ways of doing this, three given below.

  1. Exert social pressure on the free-rider to make them feel immoral. After all, few of us free-ride when we know others are watching. Do this by a grassroots effort of consciousness-raising, use the moral platform of religion, and do it in a way that all citizens participate in identifying and punishing free-riders. This is actually the normal role of social customs. Fifty years ago littering wasn't a big deal, but now almost everyone feels guilty throwing trash out their car window, and doing so in a park will earn you many harsh words. When people put “coexist” and “think globally / act locally” bumper stickers on their cars they are urging you to recycle, conserve water, and dispose of toxic chemicals properly. Some people feel so guilty for their carbon footprint that they buy carbon offsets so that their existence is carbon-neutral.
  2. Assign property rights so that there are no more free-riders. If residents' groundwater (used for drinking water) is polluted by fracking they can sue the fracker for damages. Knowing this, the fracker performs her business with care to avoid lawsuits. Elephants were almost hunted to extinction, and then an African nation tried a revolutionary idea: they made elephants the property of communities, and only those communities could decide if an elephant was hunted. Because so many people are willing to pay high prices to shoot these majestic creatures, protecting the elephant became a top priority, which meant the communities were diligent about not allowing free-riders to shoot elephants for personal gain, at the expense of everyone else. African communities became such good stewards that elephant populations rose. Yes, sometimes the best way to protect an animal from free-riders is to make it someone's property.
  3. Government action is sometimes warranted, like regulations forcing companies to use only environmentally-friendly technologies. Alternatively, government can tax companies an amount equal to the amount of externality they create. These are called Pigouvian taxes, after the economist Arthur Pigou, the main economist responsible for developing the concept of externalities. When the EPA in 2008 considered the idea of a "cow tax" equal to $175 per cow, they did so because they estimated each cow to cause $175 of environmental damage each year through its carbon and methane emissions. Nitrogen fertilizer is one of society's greatest blessings, but however much nitrogen is applied about half will leave the field, some of it entering rivers and lakes. The nitrogen then become food for bacteria and algae, and their populations can grow so large that they consume all the oxygen, resulting in eutrophication. Today, over half of America's lakes are unsuitable for fishing or swimming; the numbers for rivers and estuaries are 44% and 30%, respectively. Out in the Gulf of Mexico is a dead zone about 3,100 square miles, and most of this is caused by excessive nitrogen fertilizer. However, the nitrogen entering the gulf came from disparate regions, from Louisiana to Montana, and it is impossible to determine exactly how much negative externalities a Montana wheat farmer is responsible for. In these instances the best solution is to have government encourage more responsible farming practices that reduce fertilizer runoff. For instance, Minnesota does not allow crop production within 50 feet of a stream. Taxing fertilizer sales, like they do in Sweden, might also be a good idea.(N1)

Figure 3—Lake Erie polluted from fertilizer runoff in 2011(C1)

Figure 4—Lake Eucha, OK polluted from fertilizer and manure runoff in 2007(N1)

(E) Don't get carried away

If you really think about it, negative externalities are everywhere, and not even a government mimicking Orwell’s 1984 could ever come close to addressing them all. Too often, externalities are used to justify government action, often with bad consequences. Just because externalities exist doesn’t mean government will improve the situation. Governments often fail to craft effective policies because they too easily get captured by special interests. A great example is biofuels, where legitimate concerns about nonrenewable energy sources and externalities from oil consumption led to a corn ethanol policy that even the environmentalists hate.

This was made all too clear by Al Gore, when (no longer a politician and able to speak honestly) made the following remarks about his “mistake” in supporting corn ethanol subsidies.

Quotation 3—Al Gore admits his mistake

One of the reasons I made that mistake is that I paid particular attention to the farmers in my home state of Tennessee and I had a certain fondness for the farmers in the state of Iowa because I was about to run for President.
The Wall Street Journal. November 27-28, 2010. “Al Gore’s Ethanol Epiphany.” A16.

Video 5—The Reality of Externalities (by Learn Liberty)


(C1) Charles, Dan. May 2013. “Our Fertilized World.” National Geographic. Pages 94-111.

(N1) Norwood , F. B. and Jayson L. Lusk. 2007. Agricultural Marketing and Price Analysis. Prentice-Hall: NY, NY.

(N1) Norwood, F. Bailey, Michelle Calvo, Sarah Lancaster, and Toni Oltenaci. 2014. Agricultural Controversies: What Everyone Needs to Know. Oxford Publishing: Cambridge, MA.

(O1)Ohio History Central. Cuyahoga River Fire.  Accessed June 25, 2012 at http://www.ohiohistorycentral.org/entry.php?rec=1642.